The Pathogen, Scapegoat, Or A Miracle Drug? Short Selling And Stock Price Crash Risk

The Pathogen, Scapegoat, Or A Miracle Drug? Short Selling And Stock Price Crash Risk

Xiaohu Deng
University of Memphis

Lei Gao
Iowa State University

Jeong-Bon Kim
University of Waterloo

March 20, 2016


We identify the causality between short selling and stock price crash risk. Employing the difference-in-differences approach and a regulatory change from the Securities and Exchange Commission (SEC), Regulation SHO program, as an exogenous shock, we find that the lifting of short-sale constraints reduces the stock price crash risk, and the effect is stronger for the firms with more severe agency problems and greater information asymmetry. This study sheds light on the monitoring role of short selling in the equity market and its impact on corporate governance. In addition, our results have policy implications to security market regulators.

The Pathogen, Scapegoat, Or A Miracle Drug? Short Selling And Stock Price Crash Risk – Introduction

“Short selling has received its share of blame for market crises, even being targeted in 2008 as a reason for financial stocks to continue plummeting. However, short-sellers are often the good guys, not villains. —-CBS News, 20131

As alluded in the above quote, anecdotal evidence often claims that short selling triggers financial crisis or exacerbate market-wide stock price crash risk. Therefore, short sellers are often treated as scapegoats and held responsible for the occurrence of stock price crashes, especially during the period of financial market turmoil. This observation is one important reason why short selling is banned when the market is extremely volatile (e.g., the 2008 U.S. ban of short sales).2 In this paper, we argue that short selling does not exacerbate, but instead alleviates, the likelihood of an abrupt, large-scale decline in stock prices or simply stock price crash risk via its monitoring function. Because most of short sellers are sophisticated institutional investors, and thus, they have the ability to detect bad news promptly or to gain privileged access to private information, they can help expedite the price discovery process and improve the informational efficiency of stock prices. By facilitating a more timely incorporation of information (especially negative news), their trading activities can deter or slow down the accumulation of bad news, which in turn decreases a firm’s stock price crash risk.

When investors’ beliefs about firm value are heterogeneous and short selling is prohibited, Miller (1977) theorizes that the firm’s security is overvalued. In an efficient market, observed market prices “fully reflect” publicly available information (Fama, 1970). Short sellers, who are able to identify overvalued stocks based on their private information, should earn abnormal returns, when the prices of currently overvalued stocks are corrected later through their shorting activities. However, because of market frictions and other factors such as irrational market participants, we may not observe the informativeness of short selling. Informed investors such as institutional investors and short sellers are generally sophisticated investors, and they have ample resources to study firms in which they are investing or are planning to invest. Depending on their style, investors may “vote with their hands” by monitoring management closely or “vote with their feet” by simply taking a long or short position on their investment targets. The mechanisms of the monitoring power of those who vote with their hands by actively monitoring have been extensively studied, for example, sponsoring proposals (Gillan and Starks, 2000) or engaging in proxy fights. We enrich this literature with evidence that active traders, those who vote with their feet, also have significant monitoring power.

Since Miller’s (1977) seminal work on short selling, much work has attempted to address the consequences of the equity overvaluation problem induced by short-sale constraints. Due to these constraints, investors with negative information, who sidelined from the market until market declines, are flushed out when “accumulated hidden (negative) information comes out” (Hong and Stein, 2003, p. 487), which further exacerbates the crash risk and leads us to observe more negatively skewed returns.

Short Selling

Most of theoretical studies predict the positive relationship between short-sale constraints and stock price crash risk (see, i.e. Diamond and Verrechia, 1987; Hong and Stein, 2003). However, the findings among empirical studies are mixed. Chang, Cheng, and Yu (2007) studied the Hong Kong market and finds that volatility increases after short selling becomes available. Saffi and Sigurdsson (2010), using the skewness of weekly stock returns, find that relaxing short-sale constraints is not associated with an increase in either price instability or the occurrence of extreme negative returns. Beber and Pagano (2013) study the worldwide short selling ban and find that the ban is detrimental to market quality and destabilizes the market.

Endogeneity problems, being difficult to deal with, are the most important reason that researchers cannot reach a consensus on the role that short sellers play in the stock market. A few studies attempt to reduce the endogeneity concern by studying the short selling regulations across countries (e.g. Bris, Goetzmann, and Zhu, 2007; Charoenrook and Daouk, 2005). However, they fail to reach a consensus because the vast differences exist in institutions, investor protection, law enforcement, and etc. across countries. Different from all other empirical studies, this study employs the SEC’s Regulation SHO pilot program, as a natural experiment in which to examine a causal impact of short selling (i.e., an increase in short selling due to the temporary removal of short-sale constraints) on the stock price crash risk. To the best of our knowledge, our study is among the first to identify the causal relationship between short selling and such negative tail risk. In July 2004, the SEC announced a new regulation concerning short selling activities in the U.S. equity markets, called Regulation SHO (hereafter RegSHO). This RegSHO contains Rule 202T pilot program, in which one third of the stocks from the Russell 3000 index ranked by trading volume within each exchange were randomly selected into a pilot group. During the period from May 2, 2005 to August 6, 2007, the pilot stocks were exempted from the up-tick rule. And as a direct consequence, the barrier to short these stocks was lowered and the cost of shorting these stocks was reduced.

Short Selling

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