Short selling is an investment strategy, where an investor will borrow a security (typically from a broker-dealer or an institutional investor, such as a mutual fund), at current price and will immediately sell it. Later on, when the security’s price (hopefully) has declined, the investor will buy it back at the new price. The difference between the two prices is the profit of the investor[i]. In other words, it is a practice used by investors to speculate on the decline in a stock or other securities prices. If generalized, it will concretely induce a price decline of a security. Some might argue that the fact that an important number of investors are shorting a stock is only the genuine indication that the latter is overvalued, while for others massively shorting a stock can turn into a self-fulfilling prophecy on the stock exchange.
Unbridled short selling has been blamed by governments and some economists for exacerbating volatility during times of stress. Indeed, some would say that it can contribute to price declines in the securities of financial institutions, in a manner that is unrelated to the true price valuation[ii]. Some extreme forms of short selling can even use false rumours in order to manipulate the market and obtain the targeted (reduced) price[iii]. As a consequence, during the financial turmoil of 2008 a plethora of regulators in several countries temporarily banned short selling on certain stocks in order to improve investor confidence and reduce volatility[iv].
According to the FSMA, the outbreak of Covid-19 pandemic is at the source of substantial selling pressure and unusual volatility in the price of shares of financial institutions. As a consequence, some investors might be tempted to take new positions in order to profit from a future price decrease, which might in turn accelerate the falls already experienced in the past days and aggravate the current economic disturbance seriously. Thus, the FSMA has decided to take the following measures in a specific timeline:
1/ On the 16th of March 2020, the FSMA pursuant to article 23 of the Regulation (EU) No. 236/2012 of the European Parliament (SSR), decided the prohibition of short selling in shares that lost 10% or plus of their value on the same day. This included: AB InBev, Aedifica, Ageas, Bacro, Biocartis, CFE, Celyad, Econocom, Gimv, KBC Ancora, KBC, Kinepolis, Montea, Retail Estates, Sequana Medical, Solvac and WDP[v]. This prohibition applied for 24 hours. This measure is similar to a Circuit breaker mechanism, which is generally considered to be fairly effective[vi] and consensual[vii].
2/ On the 17th of March 2020 and updated on the 19th, pursuant to article 20 of the aforementioned regulation, the prohibition was generalized and extended until the 17th of April [viii].
The prohibition applies regardless of the place where the transaction is executed (i.e. on a trading venue or Over the Counter). The measure is only applicable to companies listed on Euronext Brussels and Euronext Growth where the FSMA is the national competent authority for the most relevant market (MRM). The ban applies to index-related instruments only if the restricted shares represent more than 20% of the index weight.
The European Securities and Markets Authority (ESMA) delivered a positive opinion on the Belgian measure[ix] as well as on similar bans taken by Italy, France, Spain and Greece. According to ESMA those bans are justified by the current adverse events that constitute a serious threat to market confidence and financial stability[x]. On the 16th of March, ESMA delivered a decision, that temporarily requires holders of net short positions in shares traded on a European Union (EU) regulated market to notify the relevant national competent authority (NCA) if the position reaches or exceeds 0.1% of the issued share capital after the entry into force of the decision. In other words, ESMA lowered the threshold for reporting short selling. Investors such as hedge funds will have to give regulators more information about the securities they are betting against[xi].
In the context of short selling bans and the Coronavirus crisis, it is interesting to note that pursuant to article 27 of Regulation (EU) No. 236/2012, ESMA has a competence to coordinate the action of regulators in different member states in order to ensure that a consistent approach is adopted. Considering the exceptional circumstances, ESMA can even issue a general ban on short selling pursuant to article 28 of the prementioned regulation.
Since the 2008 crisis bans on short selling have been considered to be controversial measures for different reasons:
Firstly, bans are incompatible with price efficiency[xii]. An extremely desirable feature of financial market is fairness which requires the market to operate in a transparent manner making available information to all participants at the same time, so that the markets can be efficient. In efficient financial markets, the prices of financial assets reflect all available information, favorable and unfavorable[xiii]. Banning short selling can possibly hinder the communication of a correct information to market participants.
Secondly, short selling is beneficial in terms of increasing liquidity on the market. Investors engaging in short selling supply liquidity to the market by increasing the number of sellers in the pool[xiv]. By that bans on short selling can jeopardize the economy[xv] by reducing liquidity on the market.
Thirdly, some studies question the effectiveness of short selling bans. Some researchers described short-selling bans on financial stocks as a factor that increased the probability of both default and volatility in the targeted companies and financial institutions[xvi].
In those times of uncertainty, one question remains, will there be an extension of those bans across Europe? And until when? All in all, it seems that it is inevitable that any future answer must incorporate an approach that balances the benefits and the costs of short sale restrictions.
The author would like to thank Prof. Veerle Colaert and Drs. Tom Vos for their comments on an earlier draft of this text.
student dual Master in Law
KU Leuven and University Zurich
[i] R. BATTALIO, H. MEHRAN and P. SCHULTZ, “Market Declines: Is Banning Short Selling the Solution?”, Federal Reserve Bank of New York, Staff Reports, No. 518, September 2011, p.1, available at https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr518.pdf.
[ii] A. BEBER and M. PAGANO, “Short-Selling Bans Around the World: Evidence from the 2007-09 Crisis”, the Journal of Finance, vol. LXVIII, no. 1, February 2013, p. 344.
[iii] M.K. BRUNNERMEIER and M. OEHMKE, “Predatory Short Selling”, Review of Finance, vol. 18, no. 6, 2014, p. 2154.
[iv] SEC Report 2008 – 211, SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets, available at http://www.sec.gov/news/press/2008/2008-211 .htm
[vi] S. KOBAYASHI and T. HASHIMOTO, “Beneﬁts and Limits of Circuit Breaker: Institutional Design Using Artiﬁcial Futures Market”, Evolutionary and Institutional Economics Review, 7(2), 2011, p. 356.
[vii] J.T. MOSER, Circuit breakers, Scientific American, February 1990, p. 2.
[xi] A. MENIN, “EU watchdog tightens short-selling rules as coronavirus sell off worsens”, CITYA.M, available at https://www.cityam.com/eu-watchdog-tightens-short-selling-rules-as-coronavirus-sell-off-worsens/
[xii] R. P. MURPHY, “A Man, A Plan, And a Short-Selling Ban”, library of economics and liberty, (Oct. 6, 2008), available at http://www.econlib.org/library/Columns/y2008/Murphyshortsell.html
[xiii] M. BRENNER and M. G. SUBRAHMANYAM, “Short Selling”, Finance Markets Institutions & Instruments, May 2009, p. 1.
[xiv] P. CINQUEGRANA, “Short selling: A known unknown”, ECMI Commentary no. 23/29, 2009, p.2.
[xv] C. A. STANLEY, “The panic effect: possible unintended consequences of the temporary bans on short selling enacted during the 2008 financial crisis”, Entrepreneurial Business Law Review, vol. 4, 2009, p. 268 available at https://kb.osu.edu/bitstream/handle/1811/78357/1/OSBLJ_V4N1_267.pdf.
[xvi] J. POWELL, “Against the short-selling ban”, the Financial Times, March 18 2020, available at https://ftalphaville.ft.com/2020/03/18/1584523654000/Against-the-short-selling-ban/