Chinmay Jain

Short Selling: The Impact of SEC Rule 201 of 2010

Despite its sizeable compliance costs, we are unable to document any clear benefits of SEC Rule 201 in ensuring fair valuations and price stability, promoting higher liquidity and execution quality, or preventing a sudden flash crash or prolonged market crises. Our daily and intraday analysis of data both before and after Rule 201 finds that short sellers are naturally more active before the occurrence of negative returns, not after significant price declines. Our simulation results show that Rule 201 further curtails short selling during normal periods, but is not binding on short sellers during the volatile period of the 2008 financial crisis.

Early Movers Advantage? Evidence from Short Selling during After Hours on Earnings Announcement Days

We examine short sellers’ after-hours trading (AHT) following quarterly earnings announcements released outside of the normal trading hours. Our innovation is to use the actual short trades immediately after the announcements. We find that on these earnings announcement days, there is significant shorting activity in AHT relative to shorting activity both during AHT on non-announcements days as well as during regular trading sessions around announcements. Short sellers who trade after-hours on announcement days earn an excess return of 0.82 percent and 1.40 percent during before-market-open (BMO) and after-market-close sessions (AMC), respectively. The magnitude of these returns increases to 1.48 (3.92) percent for BMO (AMC) earnings announcements with negative surprise. We find that the reactive short selling during AHT has information in predicting future returns. Short-sellers’ trades have no predictive power if they wait for the market to open to trade during regular hours. In addition, we find that the weighted price contribution during AHT increases with an increase in after-hours short selling. Overall, our results suggest that short sellers in AHT are informed. Our findings remain robust using alternative holding periods and after controlling for macroeconomic news announcements during BMO sessions.

Evolution of Short Selling Regulations and Trading Practices

Publisher Summary The role of short sellers in stock trading and efficient pricing is a hotly debated topic. This chapter presented a historical background on the evolution of short selling regulations and the specific rules in effect at the time of major financial crises in the United States. Most restrictions on short selling are triggered by a sharp decline in the stock market. And as short selling is considered an essential tool of efficient markets, therefore the restrictions are usually lifted after market recovery. Short selling restrictions have several formats and can affect the trading process in general, a set of stocks, or a set of market participants. The tick restrictions implemented in the 1930s and short selling restrictions on mutual funds implemented in 1940 both hamper price discovery. In contrast, the Regulation SHOs curb on naked short selling implemented in 2005 and the Securities and Exchange Commissions (SEC) temporary short selling ban on financial stocks in 2008 did not hamper the overall price discovery in stock markets. On February 24, 2010, the SEC approved a variation of the “uptick rule” to place curbs on short sales which applies to stocks that decline atleast 10% in a single day. For such stocks, short selling is allowed only if the price of the sale is above the highest bid price nationally. The nature of this rule makes it similar to the trading halts commonly adopted by exchanges around the world. This rule is expected to prevent abuse of short selling, but not at the cost of severe deterioration in the price discovery process.

Hidden Liquidity on the U.S. Stock Exchanges

We provide detailed analysis of hidden order trading on U.S. exchanges. Hidden order trades and their volume comprise about 13% and 14% of the trades and volume on U.S. exchanges. Hidden liquidity is higher in stocks with lower market capitalization, lower turnover, and lower volatility. Stocks with higher spread, greater depth, and higher prices have a higher level of hidden liquidity. Stocks listed on NASDAQ have a higher level of hidden liquidity as well. Hidden liquidity is lower at the beginning of the week and increases on Wednesdays, Thursdays, and Fridays based on number of trades and the volume executed against hidden liquidity. The aggregate level of hidden liquidity is higher on days of low market volatility. The literature has shown that hidden liquidity increases around days of earnings announcements, but we find no evidence of increases in hidden liquidity around macroeconomic news announcements. These findings are useful in understanding the level and determinants of hidden liquidity on U.S. exchanges, which is not yet understood in detail.

Algorithmic Trading and Fragmentation

Prior studies on algorithmic trading (AT) have mostly focused on a single exchange. The authors use a public dataset provided by the Securities and Exchange Commission (SEC) covering all major U.S. exchanges to study the impact of AT and its fragmentation on market liquidity. Using a proxy of AT derived from trade to order volume ratio, they find that AT concentrated on a single exchange improves liquidity. However, AT fragmentation onto multiple exchanges is associated with deterioration in liquidity. Their findings suggest a market-making as well as predatory role of AT and have policy implications.

Fails-to-Deliver before and after the Implementation of Rule 203 and Rule 204

We study the determinants of fails-to-deliver in the period before and after the implementation of Rule 203 (elimination of option market maker exception from the locate and close-out requirement) and Rule 204 (t+3 close-out rule) in September 2008. We find a positive relation between short selling and fails-to-deliver that weakens after the implementation of these rules. Fails-to-deliver are higher for stocks with low institutional ownership, low book-to-market, small market capitalization, high turnover, and put option availability. The relation between short selling and these measures of borrowing costs is also weaker after the implementation of these rules.

Dynamics of Market Liquidity and Funding Liquidity during Financial Crisis, Its Resolution, and the Volcker Rule

We provide the first empirical evidence of a non-linear relationship between funding liquidity and market liquidity (FL-ML). The relationship depends on the state of business cycle, firm volatility, and the regulatory regime. Due to heightened funding constraints, equity trading costs increased twofold during the recent financial crisis; and even more for low quality firms, confirming the “flight to quality” hypothesis. The FL-ML relationship strengthens after favorable bank stress test results indicating the importance of market intermediation by bank affiliates. The relationship weakens after the enactment of the Volcker Rule as Volcker rule prohibits proprietary trading by banks.

A Comparative Analysis of Short Selling Restrictions

Like many countries, the U.S. is concerned that short selling might destabilize markets. Currently, U.S. SEC Rule 201 restricts short selling for stocks that decline 10 percent from the previous day’s closing price. Historically, the U.S. has implemented both an uptick rule and a downtick rule to restrict short selling. Using a simulation approach, we examine the efficacy of these short selling restrictions and other alternative rules in reducing the incidence of short selling during serious market declines and leaving short selling unhindered otherwise. For each rule, we consider 5 different trigger conditions. We find that the execution rate for simulated short selling orders varies by regulatory regime and also depends on bull or bear markets condition. We conclude that a rule that takes into account a stock’s previous day’s closing price and applies to stocks with a high level of short interest is the most effective in balancing the price efficiency benefits of short selling with its panic ameliorating benefits.