A review of all existing academic studies on short selling and market volatility has strengthened calls from exchanges and hedge funds to lift the bans in place in six European countries imposed as a result of the COVID-19 pandemic. The World Federation of Exchanges published the review yesterday.

"Based on the existing evidence, the WFE recommends that financial regulators do not introduce short-selling bans, as the academic literature demonstrates not only their lack of effectiveness, but their negative impact on market quality. We would urge jurisdictions that have imposed such bans to reconsider in the light of the evidence," said Nandini Sukumar, chief executive at WFE in London.

National regulators in Spain, Italy, France, Greece, Austria and Belgium all imposed short-selling bans of at least one-month duration in mid-March. Their local stock exchanges experienced severe volatility when their respective governments introduced stay-at-home restrictions for their citizens. The regulators justified the action by stating that increased activity by short sellers was exacerbating market volatility and declines. The bans were subsequently supported by the European Securities and Markets Authority (ESMA) with the initial bans being extended till at least May 18, earlier this month.

Stefano Alderighi, senior economist and researcher, and Pedro Gurrola-Perez, head of research at WFE, who conducted the literature review, said short sellers "contribute less to price declines than regular 'long' sellers". Not only that but removing short sellers from the markets impeded efficient price setting.

"We find that the evidence almost unanimously points towards short-selling bans being disruptive for the orderly functioning of markets, as they are found to reduce liquidity, increase price inefficiency and hamper price discovery. In addition, short-selling bans are found to have negative spillover effects on other markets, for example option markets," Alderighi and Gurrola-Perez said in the paper.

The WFE paper is part of a wider push by exchanges and hedge funds represented by the Alternative Investment Management Association (AIMA) to prevent the bans being extended. AIMA had a virtual meeting with Verena Ross, executive director of the ESMA, to discuss the COVID-19 and the Short Selling Regulation (EU) No 236/2012 on March 19, just days after the supervisory authority endorsed the short-selling bans imposed by the six EU countries, according to her meetings calendar published on April 29.

Adam Jacobs-Dean, managing director, global head of markets, governance and innovation at AIMA, said the focus on its discussions with European and national authorities that had put in place restrictions was to "highlight what we see as the impact of those restrictions in terms of volatility, bid-off spreads, and performance of securities that are subject to short-selling restrictions".

'Unhelpful impact'

"It is interesting to see the WFE thorough review of the academic literature because it is really being mirrored in this situation by the metrics we are seeing from the markets. They put in place restrictions and it has had an unhelpful impact in terms of volatility. Volatility seems to be worse now after the restrictions. Spreads seemed to have widened to the detriment ultimately of investors who end up paying," Jacobs-Dean said.

Another concern with the bans was the lack of consistency as to what instruments or indices they were applied to. Jacobs-Dean welcomed the "tidying up" ESMA had done on the detail around applicable instruments covered by the Austrian, Belgian, French, Spanish and Greek bans, when it allowed them to roll over until May 18. Italy's short-selling ban was imposed for three-months and is set to expire June 18.

This inconsistency in application will be one of the things AIMA would like to see changed as part of any post-crisis review of the Short Selling Regulation.

"My hope will be that after the [crisis has passed] we can have some conversations about really what were the impact of the shortselling bans and maybe put this issue to bed," Jacobs-Dean said.