As fears resurface that Spain will need a substantial bail-out and that Italy will follow shortly afterwards, both countries have re-imposed short selling bans. The Spanish ban, which includes derivatives, will last for three months and the Italian ban will last until July 27th.

Both Italian and Spanish blue chip indexes fell about 5% to a record low before recovering on the news of the ban.

The authorities concerned obviously believe that the banning of short selling will have some effect by keeping stock prices relatively high and minimising any damage. Spain’s CNMV regulator said in a statement "The situation of extreme volatility across the European markets could interfere with their smooth functioning and the normal course of their activities."

But as Seth Setrakian, co-head of trading at First New York Securities, said to MarketBeatIt reeks of desperation. People will look now look for alternatives to hedge out their exposure”.

Professor Ian Marsh of the Cass Business School also has his doubts saying:

As expected, Spanish and Italian regulators have reintroduced bans on short selling. Regulators around the world have brought in similar bans in recent years, usually in response to plunging stock prices. The only problem is, bans on short selling don’t seem to help, at least not for long.

By removing the pessimistic investor from the market you might think the balance tilts in favour of the optimists and prices should increase (or at least stop falling). Most evidence suggests instead that apart from some hard to verify bounces on the day of the announcement, prices of stocks supposedly protected by the ban continue to move much in line with how they would have without the ban. Why? Because it isn’t really the actions of pessimistic short sellers that drive the market down. It is news about the quite awful condition of the companies and economies that cause prices to drop. When almost every piece of news about Spanish banks is bad share prices in those banks will fall, whether shorts are actively trading or not.

So why do regulators continue to introduce these bans? Maybe it is simply because they have to be seen to do something and short sellers have such a bad reputation they are popular targets.

Unfortunately bans on short selling are costly as well as useless. Excluding investors wishing to take short positions from the market – and this would include neutral funds that short one stock but buy another to hedge, as well as aggressive shorts – liquidity in the market is reduced. Reduced liquidity increases the cost of trading for everyone in the market, whether a buyer or a seller. And lower trading volumes make it harder for markets to do their key job of pricing assets accurately. Everyone knows the pessimists have been excluded and so markets have to guess where prices ought to be without the benefit of the information contained in the trades of the short sellers.”

Stock market image by Katrina.Tuliao [CC-BY-2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

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