Banning short selling to protect companies from the coronavirus crash? History suggests it won’t work

The burden of proof is on those who would interfere in company share markets rather than those who would allow them to find their own level

Financial markets in the grip of Wall Street Crash-style panic selling are enough to make a stoic sweat.

The sight of share indexes slipping by a tenth in a single day of trading – as happened in the US and the UK on Thursday – would cause even Seneca or Marcus Aurelius to cast a nervous glance at their share portfolios.

Just five more days of punishment like that and half of the value of corporations listed in New York and London will be gone.

But if you think that’s frightening, consider Spain and Italy. Spain’s stock markets plunged by 14 per cent on Thursday. And Italy – where the whole country is, of course, in a coronavirus lockdown – saw its domestic stock market slump by no less than 17 per cent.

If that rate of decline continues the value of Italy’s corporate sector would essentially vanish in just 20 days.

So in that context of carnage it’s predictable that financial regulators in Rome and Madrid have reached for one of the few levers, short of a total market closure, open to them: a ban on short selling.

Short selling is the (entirely legal) practice whereby financial traders, for a modest fee and over an arranged period, borrow some stock in a company from an institutional investor, perhaps a pension fund, then sell the stock into the open market in the hope its price will fall.

If the market obliges, the speculator will then buy the stock back at the lower market price and return it to the institutional investor from whom they borrowed it.

The short seller then gets to keep the difference between the value of the stock at which they sold it and the price they brought it back. That, minus the fee to the lender, is their profit. The bigger the fall in the price, the bigger their profit.

Listed company executives tend to dislike short sellers, particularly if they’re the ones being shorted. It’s human nature to resent people who are betting that you’re going to fail.

The generally public (to the extent that they know about it) also tend to find the prospect of financiers making money from falling share prices offensive too.

And some regulators have a problem with it too, believing that these short-selling speculators exacerbate general market routs.

The logic of the short-selling ban from Rome and Madrid (being imposed on their behalf in secondary share trading in London by the UK’s own financial regulator today) is that this will help restore order to markets.

But will it?

During the most recent market routs on this scale, the wake of the collapse of Lehman Brothers in 2008 and the Eurozone crisis a few years later, there were similar bans on short selling by some regulators.

Empirical studies of those interventions suggest that they didn’t do much good in stabilising markets and may have even made things worse by undermining transparency over prices and “liquidity”, the ability of people to trade easily.

In those episodes the big targets for the short sellers were banks, believed to be stuffed with unrecognised bad debts. One could argue that short-selling bans were damaging in that context because the banks really were bust and needed to be recapitalised by investors (or bailed out by governments) and that short sellers were merely helping to bring on this economically necessary restructuring.

Does that apply in the case of the coronavirus crash? Arguably not. Some of the biggest victims have been airlines, retailers and oil companies. There’s no suggestion of these firms hiding trillions of dollars of off-balance sheet exposures like the banks were a decade ago.

Isn’t there a danger this time that markets overshoot dangerously? Isn’t a short-selling ban a useful corrective device, like the US stock exchange “circuit breaker”, which automatically suspends trading after very large index falls?

One can make the case of course. But the burden of proof is on those who would interfere in these particular markets rather than those who would allow them to find their own level.

The Dow Jones Industrial Average, America’s most famous stock index, did go on to lose 90 per cent of its value in the Wall Street Crash of the 1920s. But even after this week’s Covid-19 carnage that index is still worth 5,000 times more than it was then.

Market meltdowns are terrifying when they happen. But in the rear-view mirror of history even the mightiest crashes tend to recede.