Did short-selling trigger the financial crash?

21 April 2015

Traders who ‘failed to deliver’ on stock market trades during the 2007-08 financial crash have been cleared of causing the collapse of major financial firms such as AIG, Lehman Brothers and Bear Stearns, according to a Warwick Business School study.

After the crash the US Securities and Exchange Commission (SEC) brought in rules to stop aggressive naked short-selling, which can produce many ‘fails to deliver’ (FTDs), as they were blamed in part for the demise of Lehman Brothers – the fourth largest investment bank in the US. A former Under Secretary of Commerce claimed that naked short selling cost investors $1 billion and drove 1,000 companies into the ground.

But research from Vikas Raman, of Warwick Business School, Veljko Fotak, of the University of Buffalo School of Management, and Pradeep Yadav, of the University of Oklahoma, found no evidence that FTDs caused the failure of financial firms and found the spikes in the number of FTDs came after the Lehman Brothers and other firms had announced they were in trouble.

FTDs occur when the position on a stock can’t be covered, either the short seller can’t afford the shares or they are not available three days after the sale. Naked short-selling - where the short seller bets that a stock’s price will fall without even borrowing the shares before selling them and then looks to cover their positions immediately after the sale - is seen as the main cause of FTDs.

Dr Raman said: “Our research found that the spikes in FTD activity came after news about the firms’ financial problems had been announced.

“There was an abnormal amount of FTDs during the crash, which you would expect. When there is negative news traders want to short-sell so there would be an increase in FTDs, but when we analysed the data we found they did not precipitate the announcements of the financial firms being in difficulty and the subsequent falls in stock prices."

Also, contrary to what has been suggested in the media and by regulators the study found FTDs do not have a detrimental effect on stock markets. It found no evidence that FTDs caused price distortions. In fact the study showed the ability to fail has a beneficial impact on liquidity and the pricing efficiency of equity markets.

For samples of both the New York Stock Exchange (NYSE) and NASDAQ, increases in FTDs lead to a reduction in pricing errors, intraday volatility, spreads, and order imbalances.

The paper, Fails-to-Deliver-Short Selling, and Market Quality, published in the Journal of Financial Economics saw the researchers analyse 1,492 NYSE stocks over a 42-month period from January 2005 to June 2008. For robustness they also looked at 2,381 NASDAQ ordinary common-share issues over the same period.

The researchers’ analysis found that large FTD changes are followed by next day improvements in market liquidity and pricing efficiency. According to the research, FTDs affected about 95 per cent of NYSE securities.

Significantly, the research found that despite a strong regulatory focus by the SEC on reducing FTDs this did not have the intended effect and had a detrimental effect on liquidity. While the SEC order banning FTDs arising from naked short sales did lead to a drastic reduction in FTDs, it also led to a significant increase in absolute pricing errors, relative bid-ask spreads, and intraday volatility.

Dr Raman added: “FTDs are not really any different in terms of impact on the market, than short-sells that eventually get covered, they bring liquidity and price efficiency, FTDs are doing the same thing.

“Yet after the crash FTDs were more or less banned in the US. Our study shows that this regulation is not supported by research, instead a mechanism that helped liquidity and price efficiency has been taken out of the market.”

Dr Raman added: “The removal of the ability to fail by the SEC and in other European countries since the crash for all public traders is somewhat debatable. They help liquidity and regulators most important role is to focus on how best to maintain liquidity and transparency in the stock borrowing market. Instead of a virtual ban on FTDs regulators could consider progressive fines for any delays in settling a trade.” 

Vikas Raman teaches Investment Management on the MSc Finance, which is also taught part-time at WBS London. Dr Raman also teaches Investment Management on Warwick Business School's Undergraduate programme.

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