The short selling ban imposed by the Financial Services Authority (FSA) on UK financial stocks in 2008 – 2009 significantly impaired the quality of UK equity markets far from being stabilising, the ban dramatically reduced liquidity and worsened problems of volatility in the prices of UK financial stocks, suggests new academic research.

In their paper, Banning Short Sales and Market Quality: The UK’s experience, Ian Marsh, Professor of Finance, and Dr Richard Payne, Reader in Finance at Cass [1], examine the impact of the ban on the 32 UK financial firms which were subjected to it and address two questions:

 Whether the ‘disorderly’ conditions and ‘incoherence’ in stock markets that prevailed prior to the ban can be identified? [2]
 Once the ban was enforced, did the change in rules on short sales do anything to remedy the ‘incoherence’ of stock market conditions, and on liquidity and market quality in particular?

Professor Marsh comments: “The answer to both questions is ‘no’. We struggled to identify any factors that would justify regulatory intervention specifically to support financial sector stocks. While prices were falling and there was strong selling pressure, this was true for both financial and matched non-financial stocks. Our market quality indicators tell a similar story. While market quality declined in the immediate run-up to the ban, it did so equally for financials and non-financials. We find no evidence that aggressive sellers were disproportionately important for the market for financial stocks. It is therefore not clear to us why the FSA felt it needed to intervene specifically to change the nature of trading in the equities of financial sector stocks. Any disorderly conditions appear to have been market-wide and not concentrated in the financial sector.

“While there were few differences between the behaviour of financial and non-financial stocks before the ban, once the ban was enacted differences become very apparent: liquidity drains from the order book for financials to a much larger extent than for non-financials; transactions costs for small and large trades increase much more dramatically and trading volumes fall much more dramatically for financials than non-financials.” Professor Marsh and Dr Payne suggest that market quality deteriorated much more for financials than non-financials and none of these moves would appear to be in line with the objectives of regulators.”

The four key conclusions of the report are:

1. There is no good reason why the Financial Services Authority (FSA) decided to single out financial stocks for special treatment as the market for comparable, non-financial stocks seemed to be behaving in the same manner.

Professor Marsh and Dr Payne find no strong evidence that conditions in the market for financial stocks were any different to conditions for stocks in other sectors in the period prior to the ban. Market quality indicators were deteriorating in late August-early September, but they were deteriorating for all stocks and not just for financial companies. Trading costs were rising and despite this trading volumes were also increasing for all stocks. Of course, stock prices were falling at this time and order flow was significantly negative as traders aggressively sold stocks, both through liquidation of long positions and through short sales. But again, conditions were similar for financial and non-financial stocks making it hard to justify the intervention by the regulators designed specifically to affect only financial sector stocks.

2. Banning short selling did not appear to improve market conditions for financial stocks relative to non-financial stocks not subject to the ban.

Liquidity in the market for financial stocks drained away and trading costs rocketed. Professor Marsh and Dr Payne find that the cost of buy orders and sell orders increased approximately equally, and that the numbers of market buy and sell orders fell by similar amounts. In other words, the ban raised the cost of trading and reduced the volumes traded but did not alter the balance of buy and sell orders. Order flow remained out of financial stocks despite the ban. This suggests that long-sellers were the real drivers of negative sentiment towards financial stocks. Moreover, if high selling pressure on financials was the real reason behind the ban, its introduction did nothing to alleviate this pressure.

3. Trading costs and market quality indicators for financial stocks were significantly worse during the ban The fall in liquidity resulted in higher price impacts following a trade, reduced market efficiency and trades conveyed less information to the market which impeded traders’ abilities to discover the true price of financial stocks. The ban served to make the trading process less informative.

Professor Marsh comments: “If by removing short sellers the FSA had hoped to make buying financial stocks cheaper or more attractive their move failed. Trading in financial stocks, whether to buy or to sell, became much more expensive and less attractive. Furthermore, we also show that the ban resulted in a shift of trading off the limit order book towards darker bilateral trading between dealers. Again, it is unlikely that the FSA wished to shift the supply of liquidity towards less transparent segments of the market as this would likely contribute to reduced efficiency and slower rates of price discovery that we observed for financials.”

4. Short sellers were accused of acting in a predatory manner, aggressively consuming (bid-side) liquidity and selling financial stocks and destabilising the market.

The results suggest, in fact, that short sellers were acting as more passive (offer-side) liquidity suppliers, willing to sell an asset if its price rose “too far” and so helping to correct over-exuberant markets. Their exclusion made the market more fragile because it reduced liquidity and worsened market quality.