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Regulation - April 23, 2010

Changing the rules of the game is the worst solution - an interview with Abraham Lioui

In this month's interview we talk to Abraham Lioui, Professor of Finance at EDHEC Business School, about his latest position paper "Spillover Effects of Counter-cyclical Market Regulation: Evidence from the 2008 Ban on Short Sales", and about his views on the role of the regulatory authorities in the stock markets.

Abraham Lioui

Could you give us some of the background to your latest position paper, "Spillover Effects of Counter-cyclical Market Regulation: Evidence from the 2008 Ban on Short Sales"?

Abraham Lioui: On 26 February 2010, in the latest of its many recent moves to restrict short selling, the SEC introduced a so-called circuit breaker that will ban short sales of stocks whose prices fell by more than 10% on the previous day’s closing. The restriction is meant to keep short sellers from driving stock prices too far below what the SEC considers their fundamental values.

Do you think that this restriction will be effective?

Abraham Lioui: Experience suggests that the circuit breaker is unlikely to break the fall. Long investors will simply sell their holdings. The outcome will be the same: the fall will continue until there is a fundamental reason for it to stop. The SEC’s implicit assertion that a fall of 10% from one day to the next is necessarily uncorrelated to fundamentals may well be nonsense. In general, it seems that the SEC is straying from its mission. Guaranteeing that trading on stock exchanges is fair is hard enough; taking a stance on whether the price of a stock is at its true value is, at the very least, highly problematic, and could be described as mission impossible.

In the position paper, I look at the impact of the ban on broad market indices in the US and in Europe (the United Kingdom, France, and Germany). Since these indices and their performance are of great concern to the asset management and hedge fund industries, it is important for practitioners and policymakers to understand the impact of changing the rules of the game (banning short sales) on the return distribution of these indices and to assess the potential spillover effects of a counter-cyclical regulation affecting only one segment of the financial market.

What are the main results of your analysis?

Abraham Lioui: That the ban had a broad impact on the markets. It was responsible for a substantial increase in market volatility. The impact of the ban on the higher moments of index returns is not systematic (skewness and kurtosis of the return distribution of only few indices were affected) or robust (using some robust measures of higher moments makes the impact of the ban disappear). Thus, the ban did not ease the downward pressure in the financial markets. The market seems not to believe that short sellers or the hedge fund industry were responsible for the turmoil of 2008.

What is your view of how market regulation should and will evolve, and what can academic research bring to the regulator?

Abraham Lioui: The recent regulatory episode related to the short ban and others show the need for a public and constructive debate as to the role of the stock markets’ regulatory authorities. Regulatory authorities such as the SEC in the US were hitherto expected to guarantee the smooth functioning of the financial markets, tracking insiders and manipulators. With the institution of the ban on short sales, regulators seemed to want to expand their powers/objective function: they wanted to attenuate the downward pressure to which the stock markets, and in particular financial institutions, were subject. Whether this expansion is legitimate is questionable, and it requires deep thought on the relevance of expanding the authorities' objective function. Even if the answer is positive, it seems clear by now that changing the rules of the game is by far the worst instrument to be used for this purpose.

A natural parallel could be made with central banks. Their role is to ensure that a proper balance is struck between price stability and economic growth. But unlike market regulatory authorities, central banks have powerful instruments such as interest-rate-setting powers and their capacity to provide liquidity to the market. So, if market regulatory authorities are to take on more ambitious objective functions they must first ensure that they have the means to do fulfil these functions. Simply banning short sales was catastrophic since it was perceived as an arbitrary (at least in the short term) decision for the authorities.

It would thus be advisable to devote more thought to the desirability of expanding the role of the regulatory authorities and, if this expansion is ultimately deemed desirable, to study the means of ensuring that, this time at least, the market authorities will shine in their newly expanded role.

As far as the contribution of academic research is concerned, it seems to me that academics can provide the regulator with neutral, objective data in what is often an impassioned debate.

About Abraham Lioui

Abraham Lioui is professor of finance at EDHEC Business School. He has published widely in and refereed for leading journals and is regularly invited to the programme committee of the European Finance Association’s annual conference. His research interests in finance revolve around the valuation of financial assets, portfolio management, and risk management. His economics research looks at the relationship between monetary policy and the stock market. He has a Doctorate in Management from ESSEC Graduate School of Business and the University of Paris I Sorbonne and an M.A. in Probability Theory from the University Pierre & Marie Curie Paris VI.