Which Short-Selling Regulation is the Least Damaging to Market Efficiency? Evidence from Europe

Abstract

Exploiting cross-sectional and time-series variations in European regulations during the July 2008 – June 2009 period, we show that: Prohibition on covered short selling raises bid-ask spread and reduces trading volume, prohibition on naked short selling raises both volatility and bid-ask spread, disclosure requirements raise volatility and reduce trading volume, and no regulation is effective against price decline. Overall, all short-sale regulations are detrimental to market efficiency. However, naked short-selling prohibition is the only regulation that leaves volumes unchanged while addressing the failure to deliver. Therefore, we argue that this is the least damaging to market efficiency.

Keywords: short selling, disclosure requirement, market efficiency, regulation, volatility

JEL Classification: G18, G14, G01, K20, O52