Short Selling Restrictions and Stock Market Liquidity: Evidence from the 2010 German Ban

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Introduction 
 
Recently, short selling bans opened a lively debate throughout both the academic 
world, and among investors, market makers and regulators: those who support the 
restrictions argue that short-selling affects markets negatively by causing panic 
selling by investors, increasing market volatility and creating the conditions for 
crashes; in contrast, the opponents of the restrictions argue that short sales increase 
the informational efficiency and liquidity of the markets and improve investors` 
ability to share risks. The last financial crises, (the subprime mortgage crisis and the 
European sovereign debt crisis) further polarized these two views on the 
effectiveness of a regulation limiting the shorting activity. 
In 2008 the main regulators reacted to the financial crisis by imposing restrictions on 
short selling. As shown by Pagano and Beber (2010) the restrictions imposed in 2008 
all over the world caused negative effects in the markets: in particularly, they were 
detrimental for liquidity, slowed down price discovery and failed to support stock 
prices. 
The aim of my work is to investigate further evidence on the effects of short selling 
restrictions, which might help securities regulators in designing regulation in the 
future. The European sovereign debt crisis in 2010 provides us with a further 
opportunity to analyze the different approaches faced by European economies in 
order to regulate short selling practice. On May 18, 2010, the German Federal 
Financial Supervisory Authority (Bafin), differently the others EU regulators, 
imposed restrictions on short selling in order to prevent a sudden and sharp decline
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in market prices caused by the aforementioned crisis. This circumstance allows me to 
estimate the effects that German short selling bans caused on its market (DAX); in 
particular I analyze the change in market liquidity after the inception date of the ban. 
Furthermore, I investigated the differences in liquidity between German banned 
stocks and unbanned ones from other stocks markets such as the English stock 
market (FTSE) and the French stock market (CAC). The results of my work show that 
the restrictions imposed by the German regulator in 2010 were particularly 
detrimental for market liquidity.  
My work is structured as follows. In the first chapter, I analyze the different short 
selling regulations imposed all over the world, focusing mostly on the U.S, European 
and Asian regulations. In the second chapter I briefly review the relevant literature 
focusing on the effects that restrictions have on securities prices, on price discovery 
and on liquidity. In the third chapter, I describe my analysis, reporting data, 
methodologies and conclusions about the impact of short selling restrictions on 
market liquidity.
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Chapter 1 
 
 
Short Selling: definition and regulation 
 
 
1.1 Definitions: Naked and Covered short sales 
 
 
In the last financial crisis the main securities regulators, in order to prevent their 
markets from crashing and to reduce the high volatility due to imbalances in orders, 
introduced constraints on short sales. Banning short sales opened a lively debate in 
the academic world: those who support the restrictions argue that short-selling 
affects markets negatively by causing panic selling through investors, increasing 
markets volatility and creating the conditions for crashes; in contrast, the opponents 
of the restrictions argue that short sales increase the information efficiency and 
liquidity of the markets and improve investors` ability to share risks.           
A short sale is defined as the sale of a security that a seller does not own. To expect to 
profit from a short sale, the short seller must anticipate a decline in the security price. 
A short seller could borrow a security from a custodian bank by paying a fee and 
selling it when he believes that the stock is overvalued. When the price falls the
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trader will buy back using the gain obtained from the previous sale and deliver it to 
the lender. The short seller will earn the difference between the sale and repurchase 
price. If the security price increases, the short investor will incur losses and he will be 
caught in a bear squeeze
1
. 
 In general short sellers are investors who hold pessimistic beliefs, usually operate in 
a bear market. Furthermore, he will incur borrowing and brokerage costs in their 
operation, which are illustrated in Figure 1.  
Thus, short selling is primarily a professional activity that is used by market makers 
and intermediaries to hedge customer business, and by investment banks or 
individual investors to express their negative views regarding a particular security 
and thus profit from it. It plays an important role in improving market efficiency since 
it fosters price corrections in overvalued securities. However, it may also be used to 
manipulate market prices, in which case it will worsen market efficiency: targeted 
securities will be artificially driven down and thus their price will not reflect their 
real value. Moreover, short sales could increase the potential risk of disorderly 
trading. The incremental weight of sell orders generated by short sales will exceed 
the buy side generating an accelerated fall in security prices and an increase in price 
volatility in the short term. That process could happen so quickly that potential 
buyers could have no time to evaluate the new scenario and take a position that could 
contrast the excessive effects of short sales. 
 
 
                                                           
1
 Bear squeeze’ or short squeeze occurs during a period of sharply rising prices caused by 
professional shorts covering their positions. The high prices force the short sellers to cover 
their shorts and realize losses.
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FIGURE 1: Schematic Representation Of Short Selling 
 
 
It is possible to distinguish two different kinds of short sales: covered short sale and 
naked short sales. A covered short sale consists of selling a security without owning it 
but insuring before the sale, that the short position is covered by the borrowing of the 
stock from a market participant. Instead, a naked short sale consists of selling a 
security short without having previously borrowed it. The investor has a pre-
determined time frame (2 or 4 days) in order to locate or buy the required stock in 
the market and thus settle the trade. Moreover, if the trader is unable to obtain the 
security within the required time frame, it will result that he has "failed to deliver" 
and could incur penalties. Nevertheless, the trade will continue to be open until the 
short-seller closes his position or borrows the stocks. Naked short sales often occur 
when it is difficult to borrow a security or when the cost of borrowing it is high.   
Naked short selling techniques have been blamed for generating excessive drops in 
stocks price, since, at least in theory, one can short an unlimited amount of a
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securities. Moreover this practice may artificially depress stock prices, since it creates 
phantom shares that are not connected with any physical security and allows a trader 
to sell it and to support the short position as long as unsettled short sales are open on 
the book of clearing house
2
.  
Before the 2008 financial crisis, short sales were not legally forbidden or restrained 
in the most important security markets, because they were not perceived as creating 
large risks or market inefficiencies. As a result, in most markets there was no legal 
definition of short sales, even though there was a general understanding in the 
marketplace about the notion of short selling. 
The United States was the sole economy that for historical reasons had legislated the 
short sales concept. In the SEC rule 3b-3 the security agency defines a short sale as: 
"any sale of a security which the seller does not own or any sale which is consummated 
by the delivery of a security borrowed by, or for the account of, the seller”. Significant 
developments in financial markets, as changes in the trading mechanism, or the 
increased availability of stocks to borrow, and the growth of investor interest in short 
selling, led the SEC to develop forms of short selling regulation. Their aim was to 
guarantee more protection to investors by improving transparency and in turn 
increasing market efficiency. 
 
 
 
                                                           
2
 A clearing house is a financial institution that provides clearing and settlement services 
for financial and commodities derivatives and securities transactions. Its purpose is to 
reduce the risk of fail to deliver in short sale transactions.
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1.2 Regulation  
 
In a period in which markets are characterized by high volatility and financial 
instability, short sellers are blamed to force and manipulate prices downward 
provoking market crashes and panic selling among investors and thus intentionally 
prolonging the recession.  The likelihood that, in a period of crisis, market abuses due 
to short seller activity could occur, induced regulators of security markets to 
undertake procedures that would have limited their actions.  
Before the 2008 financial crisis, the stock market regulators in the most important 
economies did not impose any specific regulation on short selling activity; for 
instance in the European economies, the price manipulation caused by this technique 
was regulated by the general legislation against markets abuses. A review conducted 
by the Security and Investment Board (SIB) in England in the 1997 concerning the 
liberalization of the tax regime for stock lending confirmed this behavior. The 
commission stated that:” short selling, which may increase as a result of wider access to 
stock borrowing, should be controlled through general measures to prevent disorderly 
markets rather than specific limits on the ability to sell short. However, the SIB 
concluded its review considering the opportunity to adopt some transparency rules 
on short selling or to apply specific controls to short selling in less liquid securities. 
In contrast to European countries, the United States adopted, for historical reasons, a 
specific legislation on short selling that should have limited the activity of those 
investors that could manipulate and depress prices causing crashing and disorderly 
sales.
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However, in the contest of the 2008 crisis the regulators of most country decided to 
regulate short selling.  
In 2008 the global economy risked a financial meltdown due to the security price 
drops and bank failures that began with the housing price crisis in the United States.  
This financial turmoil influenced the entire world economy. Securities regulators in 
several countries, in order to contrast the excessive fall of security prices and to 
reduce the high volatility of their market, enforced measures that restricted short 
selling.  
The stock market collapse that took place on Monday, 29 September 2008 with a loss 
of 778 points off the Dow Jones Industrial Average (DJIA), was the largest single-day 
loss in the history of the DJIA. This event is the result of a perverse financial system in 
which banks, in order to offset the risks derived from the mortgage sector, created 
the financial instruments called CDO (collaterization debt obligation) in which high 
default risk loans were pooled, tranched, and then sold via securitization to 
international institutional investors over the world. This financial innovation, that 
was mistakenly thought to stabilize the banking system by shifting the risk to those 
who were supposedly better equipped to bear it, led to an unpredictable expansion of 
credit that created a speculative bubble. The idea that this perverse financial system 
could withstand in the long run, weakened and created a soaring uncertainty in the 
market. When the market crashed, short sellers saw a chance to profit; as it is shown 
in the following graph, during 2008 the short interest ratio
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 rose deeply.  
 
 
                                                           
3
 The short interest ratio is the number of shares outstanding of a publicly traded company    
that are sold short, divided by the average daily trading volume.