Why do Short Selling Bans Increase Adverse Selection and Decrease Price Efficiency?

Abstract

When short selling is costly, owners of an asset have greater incentive to become informed than nonowners because trading on negative information is easier for them. Thus, information acquisition concentrates among investors owning the asset. A short selling ban restricts selling to only the relatively more informed investors who own the asset, increasing adverse selection but only on the sell side of the market. Price efficiency declines due to less overall information acquisition because a ban magnifies the disincentive to gather information for investors not owning the asset. Evidence from the 2008 U.S. short selling ban is consistent with these theoretical predictions.

Keywords: Adverse Selection, Price Efficiency, Short Selling, Short Selling Ban, Short Selling Regulation, Liquidity, Transaction Costs, Effective Spread, Price Impact, Realized Spread

JEL Classification: G10, G14, G18