Operate, Not Amputate: A Surgical Approach to Dealing with Toxic Short Selling

Abstract

Short selling activity is viewed by some as a toxic activity that distorts prices in securities' markets, while others consider it an integral and necessary activity for liquidity provision and price discovery. For the most part regulators allow short selling activity to take place but at times they face substantial pressure to act against short selling and introduce bans that forbid most if not all short selling activity. In 2011, the U.S.'s Securities and Exchange Commission (SEC) introduced Rule 201 that aims at striking a balance between limiting the threat (whether perceived or real) of short sellers on price stability while interfering as little as possible with the provision of liquidity and the process of price discovery. This is done by imposing very specific short lived trading restrictions that are much weaker than a generic ban on short selling. In this paper we provide a novel evaluation of the effects of this regulation by using over two years of intraday data, carefully matching treated and control assets, and separating local effects around the implementation from those over the remainder of the trading day. We find that within our window of analysis the Rule achieves its objectives: liquidity improves in lit venues and prices become more stable by increasing the cost of short selling primarily for toxic short sellers. We find evidence that the regulation achieves this by reducing downward price pressure, and the toxicity of order flow in these venues. This is accompanied by a movement of volume from lit exchanges to dark pools and a reduction in overall volume. The incorporation of negative information appears to be partially reduced, though price informativeness improves at longer (15-minute) horizons, possibly as a result of a change in the mix of informed trading. Our analysis finds that Rule 201 defines a reference for the design of future short selling restrictions.

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

JEL Classification: G14, G18