China’s Capital Markets
Navigating the Road Ahead
Rules against naked short selling are used globally and are defensible. However, the common prejudice against covered short selling is as unjustified as it is widespread. Academic consensus backed by extensive empirical evidence has documented that short selling is an essential component of well-functioning equity markets.11 For one thing, short selling is not just used to express a bearish view of the market, but is also a crucial risk management tool: many short sales are part of strategy in which an investor is both long and short and is simultaneously buying and selling or to hedge a long stock portfolio. A related example is market-making, in which short sellers provide liquidity to the market when demand spikes and then buy to offset the short positions when demand drops. Such market-making is inherently stabilizing.
The global financial crisis provided regulators and researchers with a plethora of information to assess the usefulness and impact of restrictions on short selling. The overwhelming consensus from that and other experiences is that short selling restrictions fail to restrain market declines or ameliorate volatility. In fact, restricting short selling creates significant costs and other harm to the market. Market corrections occur because of a change in perception by participants who respond by selling stocks, and short sellers typically play a valuable role in markets by helping to moderate wide swings away from fair value in both directions.12
While not prohibited in China, short selling is cumbersome and all but impracticable because the stock borrowing and lending (SBL) market is inefficient and expensive. Short selling in China will only become feasible when there is a reasonably efficient market for SBL and margin financing. Industry, exchanges and regulators should collaborate to develop rules and mechanisms to bring about such an outcome.13
11 For example, in his Nobel acceptance speech, William Sharpe made the point that the ability to sell short is a pre-condition for market efficiency. For an excellent overview of the evidence on short selling, see “A Positive Economics View of Short Selling”, Robert J. Bianchi and Michael E. Drew, Banks and Bank Systems, Volume 7, Issue 2, 2012.
12 A survey of academic studies is provided in Bianchi, Robert J. and Michael E. Drew, Banks and Bank Systems, “A positive economics view of short selling” Volume 2, Issue 2, 2012.
13″ASIFMA White Paper: The Through Train: Stock Connects Impact and Future.” ASIFMA, December 2014.
The full report is available at http://www.asifma.org/uploadedFiles/China%20Capital%20Markets%20Final%20English%20version.pdf