NEWS

May 29, 2009 posting on Ideoblog by University of Illinois Law Professor Larry Ribstein:

As I’ve discussed, e.g., here, escalating attacks on short-selling are senseless and are threatening an important engine of market efficiency. Even moderates on short-selling have a problem with (non-covering) short sellers. As I discussed here, with help from Holman Jenkins, there’s a question how serious or widespread this problem would be even in the absence of regulation. But there’s also a question whether even the naked shorting that occurs is a problem.

Now Boulton and Braga-Alves, Naked Short Selling and Market Returns, have some evidence:

“The recent financial crisis has focused a great deal of attention on naked short sellers. However, little is known about the relation between naked short sellers and market returns. We examine market returns around naked short sale transactions to address three questions.

“First, are naked short sellers momentum traders who exacerbate price declines, as some claim?

“Second, do naked short sellers possess superior information that allows them to profit from subsequent price declines?

“Third, how do market participants react to information indicating increased naked short selling activity?

“We find that naked short sellers are contrarian investors who trade following recent positive abnormal returns. Our results provide no evidence that naked short sellers are informed traders who can accurately forecast negative returns. Instead, abnormal returns are positive in the days following increased naked short sale activity. Market participants do not view announcements that indicate increased naked short sale activity negatively, as abnormal returns are generally positive following such announcements.

“Overall, our results are not consistent with the recent portrayal of naked short sellers as abusive and manipulative but instead suggest that naked short sellers promote efficient markets by providing liquidity, risk-bearing, and selling stocks they view as overpriced.”

The authors compile data on persistent failures to deliver (FTDs) withing the three-day Regulation SHO period. The most important takeaway: naked shorting does not drive down prices as critics have claimed. This theory and evidence suggests that even regulation targeted at naked shorting may be unnecessary or counterproductive. Clearly we should not be regulating all shorting as a way to get at naked shorting.

Professor Larry E. Ribstein is the Mildred Van Voorhis Jones Chair in Law at the University of Illinois.