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Regulation - April 23, 2010

Spillover Effects of Counter-cyclical Market Regulation: Evidence from the 2008 Ban on Short Sales

The ban on shorting had negative effects on the hedge fund industry. It also had a negative impact on the returns and the market quality of the stocks placed off limits by the ban.

In a new position paper, Professor Abraham Lioui looks 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.

Professor Lioui shows 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.

The present position paper is a substantial revision of “The Undesirable Effects of Banning Short Sales," an April 2009 position paper from EDHEC Risk Institute1.

In this version, the main changes are as follows:

  • The sample period has been extended.
  • Instead of individual stocks, the reaction of the broad indices is compared to the reaction of financial indices.
  • For each country one short dummy, which corresponds exactly to the length of the short ban period in the country, is used.
  • For the US, the ban experience of summer 2008 is properly controlled for.
  • A new measure of liquidity (daily trading volume) has been added as a control variable.



Reference

  1. A. Lioui. April 2009. “The Undesirable Effects of Banning Short Sales,” EDHEC Risk Institute position paper.