Operate, Not Amputate: Rule 201 as an Example of a Surgical Approach to Dealing with Toxic Short Selling

Abstract

In 2011 the SEC introduced Rule 201 aimed at striking a balance between
limiting the threat of short sellers on price stability while interfering as
little as possible with the provision of liquidity and the process of price
discovery. In this paper we provide a novel evaluation of this Rule using
over two years of intraday data, carefully matching restricted and control
assets, and separating local effects around the implementation from those
over the remainder of the trading day. We find that the Rule achieves its
objectives: despite a 4% drop in volume, liquidity and volatility improve (the
spreads fall by 7% and the range by 13%). Our analysis indicates that the
restrictions achieve this by increasing the cost of short selling in a way that
primarily affects toxic short sellers

Keywords: Short sale bans, Rule 201, overpricing, price efficiency, price discovery

JEL Classification: G14, G18