Should Bangladesh allow short selling of stocks?
Wednesday, 10 November 2010
A.F.M. Mainul Ahsan
Since existence of "bad news" is the driving force behind short selling, like politicians, CEOs also wants to conceal bad news wherever possible. But why? If presence of short selling brings so many benefits on the table, why would regulators, CEOs favour banning short sale? There are a number of possible reasons for this which serves the interest of senior management.
First, remuneration of executives is often tied implicitly or explicitly to the price of the company's stock, so anything that artificially inflates its price is likely to be welcomed in corporate boardrooms. Second, short sales ban is successful in boosting the price of the stocks involved above their free-market level, it has the effect of reducing their cost of capital and potentially causing them to expand beyond what is optimal for the firm and the economy.
Third, firms can use their stocks as "cash" to pay for acquisitions. In presence of short selling, firm's stock price will hardly be overpriced and will be somewhere nears its fundamental. Thus, the threat from short sellers is often viewed by ambitious CEOs as an obstacle to their empire-building, potentially dragging down the price of the shares that they propose to use as cash on the acquisition trail. Fourth, by propping up the share price of possible target companies, short sales bans make it easier for boards of directors to repel predators.
Effects of short selling ban during 2008: On September 19th, 2008, the SEC in the U.S. banned short-sales of shares of 799 companies. The following day similar restrictions have been imposed by the Financial Services Authority (FSA) in the U.K., the Australian Securities and Investments Commission (ASIC) and many other regulators around the world. Former Fed Chairman Allan Greenspan criticized SEC's ban on short selling and said that ban on short selling is a 'terrible idea'. The Wall Street Journal condemned the ban and said that it is like taking the 'hedge' out of hedge funds.
The ban leaves several unintended consequences. It challenged risk-lowering hedging strategies and also raised the costs of trading by widening the bid-ask spread, increased volatility, and made prices less accurate. A study initiated by the London Stock Exchange (LSE) has found that liquidity provision was impaired and market quality worsened in the affected securities while the U. K. short selling ban has been in place. Capital Markets Cooperative Research Centre (CMCRC) found that the 15 FTSE100 stocks in which short selling was banned had spreads 150% wider than other securities without the ban; the spreads went from 15 basis points to 36 basis points. Market depth, which was measured by calculating the volume required to move the bid and ask price in a stock by one percent, went down 59%.
In the U.S., between the ban's introduction on Sept. 18th and Sept. 24th, the Dow Jones Industrial Average (DJIA) fell nearly 19%. An exchange-traded fund tracking financial companies, the Financial Select Sector SPDR Fund, was down nearly 26%. As just mentioned earlier, a research published in last year shows that short sale ban in 2008, created more volatility than the financial crisis it was implemented in reaction to. A UBS research note identifies the ban as "a populist reaction of no positive value,"
It is an irony that while China, a communist country, did not ban short selling countries that "believe" in capitalism and free market did not hesitate to intrude the free market sprit by banning short sale. Laurence Copeland, a finance professor, stated in a paper presented at the CATO institute reads, "It seems that in the final quarter of 2008, the spirit of the free market was kept alive only in the People's Republic."
Short sale: Where does Bangladesh stand? To lift market efficiency and also to grab benefits of short selling mentioned above, Bangladesh need to allow short sale. To guess the future commodity prices and also to hedge risk, Bangladesh is planning to have a commodity market in near future. Without allowing short sale, the dream of having a successful commodity market will almost be unattainable. Karachi Stock Exchange (KSE) has approved short-selling for KSE-30 Index firms from January 4, 2010. In India, short selling is only open to institutional investors. Initially, Bangladesh can also allow short selling only for firms in DSE -20 index. However, short sale must be allowed after ensuring strict vigilance to get full benefit from the option.
To check free fall of share prices because of short sale, both bourses can use uptick rule or alternative uptick rule. Uptick rule refers to a trading restriction that disallows shorting securities for a price that is lower than the price of the previous trade. The newly introduced alternative uptick rule is designed to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day. Bangladesh can customize these uptick rules according to her needs.
Conclusion: Allowing short sale will provide more efficient price discovery, lower volatility, and higher liquidity than in those where short selling is banned. Most importantly, no study has proved that absence of short selling reduce the likelihood of crashes. Let's borrow few lines from Laurence Copeland again "if anything, in order to reduce the chance of another bubble in financial markets, we should be considering [...] ways to make short sales easier and more accessible to the small investor. If we believe a bias toward excessive optimism is endemic in the market, the situation will only be made worse by disenfranchising the pessimists." Frequently we listen that the stock markets in Bangladesh are overpriced; and regulators do not have many weapons to solve this problem viably other than allowing short sale in both stock exchanges.
The author is with Texas Tech University, Texas, USA and can be reached at: e-mail : mainul.ahsan@ttu.edu
Since existence of "bad news" is the driving force behind short selling, like politicians, CEOs also wants to conceal bad news wherever possible. But why? If presence of short selling brings so many benefits on the table, why would regulators, CEOs favour banning short sale? There are a number of possible reasons for this which serves the interest of senior management.
First, remuneration of executives is often tied implicitly or explicitly to the price of the company's stock, so anything that artificially inflates its price is likely to be welcomed in corporate boardrooms. Second, short sales ban is successful in boosting the price of the stocks involved above their free-market level, it has the effect of reducing their cost of capital and potentially causing them to expand beyond what is optimal for the firm and the economy.
Third, firms can use their stocks as "cash" to pay for acquisitions. In presence of short selling, firm's stock price will hardly be overpriced and will be somewhere nears its fundamental. Thus, the threat from short sellers is often viewed by ambitious CEOs as an obstacle to their empire-building, potentially dragging down the price of the shares that they propose to use as cash on the acquisition trail. Fourth, by propping up the share price of possible target companies, short sales bans make it easier for boards of directors to repel predators.
Effects of short selling ban during 2008: On September 19th, 2008, the SEC in the U.S. banned short-sales of shares of 799 companies. The following day similar restrictions have been imposed by the Financial Services Authority (FSA) in the U.K., the Australian Securities and Investments Commission (ASIC) and many other regulators around the world. Former Fed Chairman Allan Greenspan criticized SEC's ban on short selling and said that ban on short selling is a 'terrible idea'. The Wall Street Journal condemned the ban and said that it is like taking the 'hedge' out of hedge funds.
The ban leaves several unintended consequences. It challenged risk-lowering hedging strategies and also raised the costs of trading by widening the bid-ask spread, increased volatility, and made prices less accurate. A study initiated by the London Stock Exchange (LSE) has found that liquidity provision was impaired and market quality worsened in the affected securities while the U. K. short selling ban has been in place. Capital Markets Cooperative Research Centre (CMCRC) found that the 15 FTSE100 stocks in which short selling was banned had spreads 150% wider than other securities without the ban; the spreads went from 15 basis points to 36 basis points. Market depth, which was measured by calculating the volume required to move the bid and ask price in a stock by one percent, went down 59%.
In the U.S., between the ban's introduction on Sept. 18th and Sept. 24th, the Dow Jones Industrial Average (DJIA) fell nearly 19%. An exchange-traded fund tracking financial companies, the Financial Select Sector SPDR Fund, was down nearly 26%. As just mentioned earlier, a research published in last year shows that short sale ban in 2008, created more volatility than the financial crisis it was implemented in reaction to. A UBS research note identifies the ban as "a populist reaction of no positive value,"
It is an irony that while China, a communist country, did not ban short selling countries that "believe" in capitalism and free market did not hesitate to intrude the free market sprit by banning short sale. Laurence Copeland, a finance professor, stated in a paper presented at the CATO institute reads, "It seems that in the final quarter of 2008, the spirit of the free market was kept alive only in the People's Republic."
Short sale: Where does Bangladesh stand? To lift market efficiency and also to grab benefits of short selling mentioned above, Bangladesh need to allow short sale. To guess the future commodity prices and also to hedge risk, Bangladesh is planning to have a commodity market in near future. Without allowing short sale, the dream of having a successful commodity market will almost be unattainable. Karachi Stock Exchange (KSE) has approved short-selling for KSE-30 Index firms from January 4, 2010. In India, short selling is only open to institutional investors. Initially, Bangladesh can also allow short selling only for firms in DSE -20 index. However, short sale must be allowed after ensuring strict vigilance to get full benefit from the option.
To check free fall of share prices because of short sale, both bourses can use uptick rule or alternative uptick rule. Uptick rule refers to a trading restriction that disallows shorting securities for a price that is lower than the price of the previous trade. The newly introduced alternative uptick rule is designed to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day. Bangladesh can customize these uptick rules according to her needs.
Conclusion: Allowing short sale will provide more efficient price discovery, lower volatility, and higher liquidity than in those where short selling is banned. Most importantly, no study has proved that absence of short selling reduce the likelihood of crashes. Let's borrow few lines from Laurence Copeland again "if anything, in order to reduce the chance of another bubble in financial markets, we should be considering [...] ways to make short sales easier and more accessible to the small investor. If we believe a bias toward excessive optimism is endemic in the market, the situation will only be made worse by disenfranchising the pessimists." Frequently we listen that the stock markets in Bangladesh are overpriced; and regulators do not have many weapons to solve this problem viably other than allowing short sale in both stock exchanges.
The author is with Texas Tech University, Texas, USA and can be reached at: e-mail : mainul.ahsan@ttu.edu