Banning Short-Selling During Financial Crises – An Optimal Approach?

[Talin Bhardwaj is a third-year student of B.A. LL.B (Hons.) at the Rajiv Gandhi National University of Law, Patiala]

The unprecedented circumstances emanating from the Covid-19 pandemic have created major instability in the financial markets of various countries that has been detrimental to the confidence of investors. This economic crisis has forced financial regulators around the world to take measures to maintain financial stability, for instance, by curtailing short selling. The Securities and Exchange Board of India (SEBI) and financial regulators of various member nations in the European Union (EU) had imposed restrictions on short selling for countering financial volatility in these distressed times. The decision of various financial regulators to curb short selling has, on one hand, been regarded as one of the most basic and effective measures to restore financial stability. However, on the other hand, it has also been regarded as a traditional approach, whereby some commentators believe that the effective usage of short selling can help in removing the current liquidity crunch in economies throughout the world.

This post shall, first, briefly explain the concept of short selling in the context of the pandemic. Secondly, it shall provide a detailed analysis on the actions of SEBI, various financial regulators in EU and regulators of other nations to ban short selling, and thereby assess the viability of banning short selling during financial crises.

Short Selling Amidst the Pandemic

EU Regulation No 236/2012 and SEBI’s discussion paper on Short Selling and Securities Lending and Borrowing elucidate that short selling is a long-standing financial practice in which the stock is sold when the seller does not own the stock at the time of the trade. It is regarded as an investment strategy whereby the investor borrows the stock from either a broker or an institutional investor and sells it immediately at the current price speculating that its price would decrease due to the excessive supply of that stock in the market. The investor thereafter buys the stock back at a lower price.

Several experts believe that short selling increases the volatility in the market and should, therefore, be curtailed during financial distress, as was done by many governments during the 2008 global financial crisis. Considering the recent bans, it becomes evident that financial regulators in many countries including India and EU nations still perceive short selling as a bane, especially during an economic crisis. However, this is typically a traditionalist approach as this theory completely ignores the benefits of short selling. The greatest benefit that short selling provides in an economy is the increased liquidity, which is a sine qua non during these times of the pandemic. Additionally, the proponents of the contemporary perspective on short selling opine that short selling helps in facilitating communication regarding the genuine price of the stock, which thereby enhances transparency and price efficiency in the market. Having discussed the concept of short selling along with the traditional and the contemporary perspectives, the next section shall deal with the status-quo pertaining to the imposition of bans by SEBI and many EU regulators.

Bans on Short Selling: Have they Become a Norm during Crises?

The debate revolving around the viability of banning short selling has been reinvigorated in light of the recent imposition of bans by many regulators amidst the pandemic. This section aims to provide a comprehensive analysis about the actions taken by various regulators pertaining to short selling amidst the pandemic.

SEBI had initially introduced restrictions on short selling for a period of one month through a circular dated March 20, 2020. However, considering the need to protect the market from volatility, SEBI further extended these restrictions on short selling till July 2020. Moreover, other EU nations such as Belgium, Italy, France and Spain had introduced bans on short selling, pursuant to article 20 of the EU Regulation. Apart from India and several EU nations, China has also imposed stringent restrictions on short selling to stabilise its financial markets. The actions of these regulators clearly suggest that they hold a traditional view on the concept of short selling.

On the other hand, USA, UK and Germany have not banned short selling. Additionally, even though the European Securities and Market Authority (ESMA), a common financial regulator for the EU nations, initially supported the decision of States to impose bans on short selling, it ultimately decided that such bans can not be extended beyond May 18, 2020. ESMA’s intervention pertaining to the time period of the ban manifested its intention to keep the bans for a limited time, as a blanket ban for a long period of time may harm the liquidity levels in the market.

Assessing the Viability of Bans

Majority of the financial regulators believe that banning short selling is effective for reducing fluctuations in the market. However, there is no statistical evidence to prove that a ban on short selling helps in reducing market volatility. The example of 2008 financial crisis is pertinent in this context. The Securities and Exchange Commission (SEC) of USA decided to ban short selling when the equity index was falling sharply during the global recession. Nonetheless, the stock prices kept declining despite the restrictions imposed by the SEC and other financial regulators of various countries. There was no difference in the market stability of nations that banned short selling and nations that did not ban short selling during the 2008 crisis, which could be substantiated by comparing India and USA.

Moreover, many countries have not experienced a considerable improvement in reducing market volatility by banning short selling amidst the pandemic.  Therefore, both the historical as well as contemporary evidence suggests that imposing a blanket ban on short selling is not an efficacious option during times of financial distress. Further, the statistical failure of the traditionalist approach during the global recession was the major contributing factor towards the rising support for the contemporary perspective on short selling.

Apart from the benefits of an increased market liquidity provided by short selling during the time of financial crises, the proponents of the contemporary perspective provide a two-fold argument against banning short selling. First, a blanket ban is not a viable option since there are many other safeguards in financial markets imposed by the market regulators, such as circuit breakers to curtail selling beyond a certain point and prevent exacerbated volatility in the market. Second, in furtherance to the increased liquidity created by the process of short selling, the sellers are usually able to create an equilibrium between the demand and supply of stocks in the longer run. Therefore, past experiences along with the dire need of increasing the liquidity in the market during the pandemic suggests that various regulators need to reconsider the strategy of banning short selling and adopt a more contemporary perspective.

Conclusion: Recognizing the Optimal Approach

Undoubtedly, the financial impact on various economies throughout the world is bound to last even after the pandemic. Pertinently, the financial crisis has not affected all the economies in a similar manner, which implies that there cannot be a uniform policy by all nations to cope with the crisis and control market volatility. However, evidence suggests that banning short selling is not a viable option to deal with a financial crisis, irrespective of the financial impact of the pandemic on nations.

An alternative approach such as strengthening the circuit breaking mechanisms can be considered by the regulators. This approach was initially adopted by the Financial Services and Markets Authority (FSMA) of  Belgium pursuant to article 23 of the EU Regulation, whereby some restrictions were imposed on short selling for only a limited time, and specifically only for the stocks that lost more than 10% or more of their value in a single day. This approach fulfils the objective of achieving market stability without compromising on the benefits of liquidity and price realisation that accrue from short selling. Thus, instead of imposing blanket bans on short selling during any financial crisis, regulators of various countries can consider adopting this approach in the near future, wherein certain restrictions are imposed on short selling, although these restrictions may be limited both in time and scope.

– Talin Bhardwaj