Talk of banning short sales is suddenly in the air, but history argues against it

Published Fri, May 5 20238:56 AM EDT

It's 2008 all over again. Bank shares are dropping like a rock. Investors are worried. Why are they dropping? Deposit flight worries? Commercial real estate overhang? More regulations coming from Washington? No. Those are just the obvious reasons. But, as with all panics, the conspiracy theorists are out. It couldn't be this obvious. There must be another reason. Maybe it's market manipulation! Maybe it's those nefarious short sellers! "U.S. officials at the federal and state level are assessing the possibility of 'market manipulation' behind big moves in banking share prices in recent days," Reuters reported Thursday, citing various sources who indicated short sellers were making money on the recent decline in banks. Well, there's your story. Prices are going down. Short sellers are making money. Therefore, market manipulation. It's just a hop, skip and a jump away from the obvious conclusion: ban short sellers! That will solve the problem. David Brown, chief executive of New View Economics, was an employee of Bear Stearns when it went under in 2008 and was acquired by JPMorgan. In a recent editorial in the South China Morning Post, Brown noted with approval that the SEC stepped in to ban short selling of financials in September, 2008 and suggested that it was time to do it again: "If the move was warranted then, why not now, when the world might be on the threshold of another global meltdown? At some point, the wanton destruction of global wealth at the hands of hedge funds, leveraged speculators and proprietary traders in the pursuit of profit has to stop. The world cannot afford to deal with another major financial crisis so soon after the Covid-19 pandemic, the global inflation spike and with the Ukraine war still raging." Have you heard this story before? In September, 2008, U.S. regulators did indeed briefly ban the short-selling of financial stocks, claiming the practice was driving down the price of bank stocks. It was a bit late: by then, the SPDR Bank ETF (KBE), a basket of large bank stocks, had already plunged about 50% from its high in February, 2007. The ban lasted for about two weeks. Did the ban solve the collapse of the banks? No. From September 2008, the Bank ETF dropped an additional 60% before bottoming in March, 2009. A 2012 paper published in the Federal Reserve Bank of New York's Current Issues in Economics and Finance concluded that "The preponderance of evidence suggests that the bans did little to slow the decline in the prices of financial stocks. In addition, the bans produced adverse side effects: Trading costs in equity and options markets increased, and stock and options prices uncoupled." Jim Toes, President and CEO of the Security Traders Association, hopes that the SEC is not considering a similar ban this time around. "Back in 2008 the SEC's impulsive reaction to ban short-selling added chaos to an already chaotic situation," he said in an email. "Why would it be different this time?" There are already rules to prevent violation of short selling rules Fortunately, the SEC has not (at least yet) jumped on this bandwagon. Sources tell me that SEC Chair Gary Gensler is not currently contemplating a ban on short selling. Gensler, however, has made it clear he is looking out for bad actors who may be violating existing laws on short selling. "As I've said, in times of increased volatility and uncertainty, the SEC is particularly focused on identifying and prosecuting any form of misconduct that might threaten investors, capital formation, or the markets more broadly," Gensler said in a statement released yesterday. Gensler's predecessor as SEC Chair, Jay Clayton, seems to agree with him: "I do not see a current need for banning short selling as that is generally viewed as a temporary measure that has little or no effect," he said in an email. "The SEC should be focused on preventing manipulation." There are many rules governing short selling. For example, there are rules that prohibit naked short selling , the practice of short selling shares that haven't first been borrowed. The trading community seems supportive of any efforts to go after bad actors. "If someone is violating the short selling rules, then something should be done about it," Brett Redfearn, former Director of the SEC's Division of Trading and Markets, said in an email. "But that is very different than a ban on short selling." Toes agrees with this: "Perhaps the regulators should consider putting firms on alert that violations of existing short-selling rules resulting from either nefarious behavior by bad actors or some kind of human error, such as a misinterpretation of the rule or poorly designed compliance technology, will be dealt with severely," he told me. "This may achieve their intended goal without creating an unforeseen negative consequence." Even the American Bankers Association, which has been appalled at the decline in the shares of its member banks, has not called for an outright ban on short sales. Instead, it's urging Gensler to "consider all its existing tools and to take measures to reduce the avenues for abusive trading practices and restore investor confidence." Redfearn emphasized the value that short sellers bring to the market. "Most market participants look at short selling as an integral part of the financial ecosystem," he told me. "They help to identify overvalued companies (and sometimes fraud) and contribute to efficient stock prices. When short selling is banned, traders who want to buy stock but need to hedge their risk will be hesitant to do so."