Limiting Short Selling During Periods of Individual Stock Stress Reduces Volatility and Raises Prices

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policies of the OFR or Treasury.

A working paper published today by the Office of Financial Research (OFR) finds that temporary short-selling restrictions, triggered by a sharp decline in a stock’s price, reduce market volatility and improve pricing and market liquidity.

Short selling is a trading strategy that investors employ when they believe the price of a stock will decline or when they need to hedge their portfolio to protect it from declines in a particular stock’s value. In times of market stress, regulators have temporarily banned short selling. In the United States, it is now partially and temporarily restricted when the price of a stock declines by 10% or more.

Despite the common use of short-selling restrictions and a significant body of research investigating their impact, research findings are mixed, and definitive conclusions about the impact of short-selling restrictions on financial stability are hard to come by. The OFR sought to quantify the impacts of short-selling restrictions to illuminate the role these limits could play during financial downturns and periods of market turmoil.

What Are the Working Paper’s Main Findings?

OFR researchers used the 10% threshold–based policy to quantify the impacts of short-selling restrictions. Using data on intraday prices and trading outcomes, the OFR made the following findings:

• Short-selling restrictions increase returns by 35 basis points per day and roughly 56 basis points over the full course of a typical short-selling restriction episode (approximately 1.6 days). These impacts on price persist in the days after restrictions are lifted.
• Short-selling restrictions lower spot volatility, indicating that restrictions on short sellers stabilize price movements.
• Short-selling restrictions result in narrower spreads and an increase in depth at best ask price, which is consistent with the policy’s rule restricting short sellers from placing marketable limit orders. It is likely that at least some short sellers switch from removing liquidity from the bid side to providing liquidity on the ask side.

What Are the Financial-Stability Implications?

Short selling is often cited as a threat to market stability and price efficiency in times of crisis, but research neither supports this view nor clearly corrects it. Downward price pressure is most pernicious in stocks that have declined in value. Excessive downward pressure could result in adverse feedback loops and fire sales. The effects of this policy are likely most relevant to stocks that experience large negative returns. However, identifying the impacts of short selling and short-selling restrictions in stocks experiencing price declines is important to gaining an understanding of how and when such adverse feedback loops occur and how they may be avoided. Moreover, despite the restrictions being short-lived, the price impacts are persistent.