In a 2012 edition of the New York Fed’s Current Issues, Robert Battalio, Hamid Mehran, and Paul Schultz discuss how short-sales work and whether bans on short-sales have had the desired effect of slowing down stock price declines. They haven’t.
Our analysis of the empirical evidence from the United States suggests that the bans had little impact on stock prices. Even with the bans in place, prices continued to fall. At the same time, the bans lowered market liquidity and increased trading costs. …
Short-selling is the selling of borrowed shares by investors who expect to cover their positions later by repurchasing the shares at a lower price. … during 2005 it accounted for 24 percent of trading volume on the New York Stock Exchange and 31 percent of Nasdaq trading volume.
Most short sales are conducted by market makers or high-frequency traders, or by options market makers who short to hedge their options positions. Market makers and high-frequency traders generally do not maintain short positions for long periods. In fact, they typically close them within minutes or even seconds of opening them.
Our focus is on investors who short stocks for longer periods because they believe the stocks are overpriced; they expect to profit by repurchasing the stocks after prices have fallen. These investors generally borrow the shares from an institution, often one with a passive investing strategy. In exchange for the stocks, the borrower places collateral, usually cash, with the lender. (The standard collateral for U.S. equities is 102 percent of the shares’ value.)
The lender of the stocks pays interest on the collateral at a rate that is negotiated between the borrower and lender—referred to as the rebate rate. For stocks that are easy to borrow, rebate rates may range between 8 and 25 basis points below the federal funds rate …
Despite concerns that short-selling can artificially drive prices below fundamental values, it is not easy for investors to make money in this way. Short sales may depress stock prices, but the short-seller profits only after buying back the shares at low prices to close the position. If purchases and sales have a symmetric impact, such that a sale of shares moves prices down by about the same amount as the purchase of the same number of shares would raise prices, prices will rise to their original levels when the short-seller buys back the shares. In that case, the short-seller will not profit from this strategy and will instead lose money on trading costs.
One way for a short-seller to make a profit shorting a stock that is not overvalued is to somehow fool other investors into selling him the shares at a price that is lower than the one he charged the original investors. This is a risky scheme, however, and may prove very unprofitable. … Moreover, if short-sellers spread false rumors about a company or attempt to manipulate its share price, they are engaging in illegal activities and the targeted company may fight back.
… Lamont (2004) finds that, on average, the stocks of the targeted companies underperformed the market the following year by a whopping 24.7 percent. … “many of the sample firms are subsequently revealed to be fraudulent.”
In addition, investigations into the activities of the short-sellers were requested by sixty-six of Lamont’s sample firms. As Lamont notes, if the Securities and Exchange Commission (SEC) had found that these short-sellers were spreading false rumors, manipulating prices, or committing other illegal acts, their criminal activity would have been revealed and the stock would have rebounded. In fact, the companies that requested investigations earned abnormal returns of -27.7 percent the following year.
Another way in which a short-seller can profit from shorting a stock … is by weakening investor confidence in the firms whose stocks are shorted. This seems to have been a concern of the SEC when it imposed the 2008 ban on short sales. …
Still, it might take time to damage a financial firm in this way. Prices may need to be held artificially low for an extended period. Moreover, the firm would have an interest in convincing investors of the soundness of its assets. If other smart investors believed that the financial firm’s assets were solid, they would trade against the short-sellers, making the shorting strategy a risky one.
The Guardian reported in 2011 when four European countries introduced bans on short-sales while the UK did not.