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1 Market Regulation Services, Inc. (Canada) Literature Review Shortselling Carole Comerton-Forde Karmei Tang 28 October 2005

2 Table of Contents About the CMCRC... 3 About the Authors... 4 Executive Summary Introduction Jurisdictional Review of Short Selling Price Restrictions Price restrictions on short selling in Canada Price restrictions on short selling in the US Price restrictions on short selling in other markets Review of the literature on short selling Price discovery and market volatility Preventing the exacerbation of market declines Preventing bear raids and market manipulation Conclusion References Appendix Appendix CMCRC Literature Review Short Selling Page 2 of 30

3 About the CMCRC The Capital Markets Cooperative Research Centre was formed in 2001 to bring together the best in innovative research and technology to the capital markets domain. Positioning itself as a bridge between the practical needs of capital markets and pioneering academic research, the Capital Markets CRC (CMCRC) was formed under the auspices of the Federal Department of Education Science and Technology (DEST) Cooperative Research Centre (CRC) program. Having achieved the goal of attracting key industry and research participants as partners in the program, the CMCRC was granted funding of $62 Million over seven years to foster research that is both leading edge and industry relevant. The CMCRC is the initiative of a group of researchers and industry partners who have an impressive track record of commercial success. The CMCRC formula attracts the best of Australia s researchers to work together with industry partners to develop new and innovative technologies for the capital markets domain. Headed by Chief Executive Officer, Professor Mike Aitken, the CMCRC harnesses the combined research resources of approximately 40 senior researchers from the fields of finance and technology. A similar quantum of human resources is provided by industry partners who also assist in guiding research resources to problems and issues that will make a significant difference in the future operations of global capital markets. Contacts Street Address Capital Markets CRC Limited, Level 2, 9 Castlereagh Street, Sydney NSW 2000, Australia Postal Address GPO Box 970, Sydney NSW 2001, Australia Phone +61 (2) Fax +61 (2) cmcrc@cmcrc.com ACN CMCRC Literature Review Short Selling Page 3 of 30

4 About the Authors Carole Comerton-Forde Dr Carole Comerton-Forde is a Senior Lecturer in Finance at the University of Sydney. Carole graduated with a Bachelor of Commerce with First Class Honours in Finance and a Doctor of Philosophy (Finance) from the University of Sydney. Carole s research focuses on security market microstructure and issues related to market efficiency and integrity. Her research has been published in academic and industry journals including the Journal of Financial Markets, Journal of Financial Services Research and the Pacific Basin Finance Journal. Carole has been involved in a large number of research projects for the Australian Stock Exchange and other market organizers and regulators. These projects include an examination of a delayed reporting regime for large block trades, an analysis of the impact of the introduction of a closing call auction on market liquidity and analysis of the impact of the pre-trade display of broker identities on liquidity Karmei Tang Karmei Tang is enrolled in the PhD program in the School of Business, in the Faculty of Economics and Business at The University of Sydney. She has graduate and postgraduate qualifications in finance and statistics, respectively. Returning to study after seven years in securities market regulation, her principal research interests relate to the impact of securities market regulation and market microstructure design on market efficiency and integrity. CMCRC Literature Review Short Selling Page 4 of 30

5 Executive Summary The purpose of this paper is to present a review of the academic literature on short selling, with particular focus on the implications of short selling price restrictions on market efficiency and integrity. This review was commissioned by Market Regulation Services Inc. ( RS ) as part of its current Strategic Review of the Universal Market Integrity Rules ( UMIR ). To set the practical context, the paper begins with a brief summary of the relevant short selling restrictions in Canada, the US and global markets. The subsequent sections review the various theories and corresponding empirical evidence on the role of short selling price restrictions in: (i) price discovery and market volatility; (ii) arresting destabilizing market declines; and in (iii) preventing bear raids and similar manipulative behavior. Generally, existing empirical evidence suggests that tick rules are of limited use in arresting market declines. Conversely, they typically act to restrict price discovery by limiting arbitrage and creating overpricing of securities, thus affecting overall market efficiency and liquidity. There are relatively fewer empirical studies on the role of short selling in market manipulation, due to the difficulty in investigating such activity; however, the general argument in the studies that have looked at this also tend to argue that price restrictions are ineffective and unnecessary in preventing bear raids and market manipulation. Based on the existing body of work in this area, it would appear that there is a case for the removal of the zero tick rule in Canada if the primary objective is to prevent market manipulation. However, one also needs to consider the fact that existing short sale restrictions in Canada are relatively less stringent than in the US, where the majority of the empirical studies were conducted. It is recommended that, as part of its decision-making process on whether to remove the zero tick rule, RS closely examines the role of the existing price restrictions in the price discovery process in the Canadian securities market. This should include an examination of other aspects of market quality such as execution quality, liquidity and volatility. It should also examine the historical magnitude of, and trends in, short selling in the Canadian securities market, the extent to which short selling has played a role in market manipulation cases initiated by RS, the extent to which such activity can be carried out within the confines of the tick rule and existing exemptions, and the potential implications of removing the rule for market quality and investor protection. At the same time, RS may wish to consider a closer examination of the process by which it can more effectively monitor the non-disclosure of short sales by participants intending to manipulate the market. This would facilitate the ongoing surveillance of short selling activity, which will be critical to market confidence particularly if the price restrictions are eventually removed. CMCRC Literature Review Short Selling Page 5 of 30

6 1. Introduction The purpose of this paper is to present a review of the academic literature on short selling. This review was commissioned by Market Regulation Services Inc. ( RS ) as part of its current Strategic Review of the Universal Market Integrity Rules ( UMIR ) and prepared by Dr. Carole Comerton-Forde and Karmei Tang of the Capital Markets Cooperative Research Centre. Short selling refers to an activity where an investor sells a stock without actually owning it first. Investors are often required to borrow the stock before shorting it; the investor then purchases the stock later to cover the borrowed stock. In a naked short sale, the shares are sold short without borrowing stock to back them up. Such activity is however often restricted if not altogether prohibited in many jurisdictions. In the Canadian securities market, UMIR Part 3 specifically addresses the regulatory parameters under which short selling activity can be conducted. We seek to answer in particular the question of whether price restrictions should apply to short sales. The following sections provide a discussion of price restrictions on short selling in Canada and other jurisdictions, a review of the academic literature on short selling and the policy implications arising from this literature. The paper concludes with a summary of the main results and policy implications gained from this literature review. CMCRC Literature Review Short Selling Page 6 of 30

7 2. Jurisdictional Review of Short Selling Price Restrictions Many markets that permit short selling have an uptick or zero-tick rule prohibiting short sales at prices below the last traded price. Figure 1 presents the definitions of the different kinds of tick rules normally applied to short selling. This is followed by an overview of the relevant rules and regulations on short selling price restrictions in Canada, the US and other jurisdictions. Figure 1: Definition of various short selling tick rules Uptick/Plus tick Short sale can only be executed at a price higher than the preceding trade price. Zero uptick/ Zero plus tick Short sale can be executed at an uptick or at the same price as the last trade price of the particular stock, if the most recent price movement preceding that trade was upward. Zero tick Short sale can be executed at an uptick or at the same price as the last trade price on the exchange Price restrictions on short selling in Canada In the Canadian securities market, short selling is regulated under UMIR Part 3 and various sections of the Rules of the Investment Dealers Association of Canada (IDA Rules). The following is an overview of the current short selling regulations in Canada: (i) Disclosure rules. UMIR Rule 6.2(viii) and (ix) require short sale orders to be designated, or identified, as such in the order entry. However, this designation is not disclosed in the consolidated market display (UMIR 6.2 6(b)). The aggregate short position of all short sales must be calculated by brokers/market makers on a semi-monthly basis; that is, on the 15th and last days of each month. These figures must be reported to the exchange not more than two days later each calculation date. The exchange makes these reports available to members and subscribers one day later, and the information is reported to the media with a lag of approximately one week. 1 Anonymous short sale orders and short sale iceberg orders are accepted. (ii) Location/availability. Investors are not generally required to locate a stock for borrowing before they can make a short sale. The participant is merely obliged to assess the credit risk and settlement risk associated with the short sale, and the selling party should have reasonable belief that the stock will be available to the short seller before the settlement date of the short sale. Where the trade (or conversion or exercise) where the seller is to acquire the securities fails through no fault of the seller they will not be considered to have violated UMIR. 2 1 Source: Ackert and Athanassakos (2005). 2 Market Regulation Services Inc., Market Integrity Notice No , August CMCRC Literature Review Short Selling Page 7 of 30

8 (iii) Margin requirements. Margin requirements for shortselling are set out in Regulation (f) of the IDA Rules. For stocks priced at $2 or more, participants are required to post a margin of 150% of market value before short selling. 3 The margin requirement can be lower for stocks with associated options. The minimum short selling margins for stocks priced between $1.50 and $1.99 is $3 per share; for stocks priced between $0.25 and $1.49 is 200% of market value; and for stocks under $0.25 is market value plus $0.25 a share. (iv) Zero tick rule. UMIR Part 3.1(1) sets out the zero tick rule which prohibits a Participant or Access Person from making a short sale unless the price is at or above the last sale price. There are however various exemptions that allow a short sale to be made below the last sale price if the sale is: (i) a program trade; (ii) to satisfy market maker obligations; (iii) for an arbitrage account under certain conditions; (iv) for a derivatives market maker under certain conditions; (v) the first sale of an ex-dividend, ex-rights or ex-distribution basis stock under certain conditions; and (vi) a market order in the call auction, a market-on-close order or a volume weighted average price order Price restrictions on short selling in the US Short selling in the US is regulated by the Securities and Exchange Commission (SEC) as set out in Section 10 of the Securities and Exchange Act of 1934 ( the Act ). Also, Section 7 of the Act gives the Federal Reserve Board oversight of margins on short sales. Ferri, Christophe and Angel (2004) provide a useful overview of the various measures in place in the US to control short selling in its stock markets. They include the following: (i) Disclosure rules. All sale orders must be marked as long or short ; the latter is to allow for greater transparency when a short sale has occurred. Brokers are also required to report the short interest of their customers once a month. These figures are collected on the 15 th of each month and publicly disseminated after a few days, usually within a week of the compilation date. The various exchanges also have additional requirements for the recording of short sales information. (ii) Location/availability rule. Investors are generally required to locate a stock for borrowing before they can make a short sale (Rule 10a-b of the Act). NASD 3370 requires investors to make an affirmative determination that they can borrow the stock before they sell it. (iii) Margin requirements. Short sellers are required to post a 50% margin before short selling, as required under Regulation T which is administered by the Federal Reserve Board. Short sellers are not allowed to access the short sale proceeds (iv) Uptick rule. Rule 10a-1 of the Act requires that short selling can only be conducted on an uptick. On the NYSE, a short sale may only be done on an uptick or a zero plus tick (which occurs when the price is the same price as the last trade, but higher than the previous different trade). (v) Bid test. Since 1994, Nasdaq NMS stocks have been subject to a bid test under NASD 3350 and IM-3350 which prohibits short sales at the bid price if the bid was less than the previous inside bid price. (vi) Restrictions in anticipation of corporate actions. Regulation M Rule 105 prohibits manipulative shorting in anticipation of an offering. 3 This definition is equivalent to what is referred to in the US as a 50% margin. Because the proceeds of the short sale would automatically constitute 100% of market value, the short seller would only need to deposit the balance of the funds or, in other words, a 50% margin. CMCRC Literature Review Short Selling Page 8 of 30

9 Rule 10a-1 of the Act is of particular interest to our review, as it stipulates that short selling is only permitted following a trade where the traded price was higher than the previously traded price (uptick). The objectives of the uptick rule are three-fold: (i) (ii) (iii) Allowing relatively unrestricted short selling in an advancing market; Preventing short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down; Preventing short sellers from accelerating a declining market by exhausting all remaining bids at one price level, causing successively lower prices to be established by long sellers. 4 The uptick rule has been in place since February There have been recent developments relating to this rule as part of broader reforms aimed at curbing abuses of short sales. Table 1 presents a summary of the public comments gathered during the course of the SEC s consultations on its Concept Release on these proposed reforms in As a result of these discussions, the SEC adopted Regulation SHO in September The new provisions included a new temporary Rule 202T allowing the SEC to temporarily suspend the uptick rule and any short sale price test of any exchange or national securities association, for certain designated securities, under a one-year pilot program. This was done in order to allow the SEC to evaluate the overall effectiveness of such restrictions, and to permit the collection of data on the impact of short selling in the absence of a price test. This pilot program commenced from 2 May 2005 and will terminate on 28 April Short-sold designated securities would need to be marked as short exempt instead of short or long under Regulation SHO s new short sale marking provisions. Self-Regulating Organizations (SROs), including the exchanges, would be responsible for actively monitoring trading in these securities to identify any abusive short selling. The NASD s bid test does not apply to transactions in NASDAQ-listed stocks executed on the Archipelago Exchange (ArcaEx). (In general, NASD's rules do not apply to NASD members when those members execute orders in OTC stocks on the ArcaEx). Short sales that are routed outside the ArcaEx Book are subject to the short sale rules of the away market. Appendix 1 provides further details on the short selling regulations in the US, including on ArcaEx. 4 Summary of Comments, SEC Concept Release: Short Sales, Release No (October 20, 1999), File No. S Originally from the Report of Special Study of Securities Markets of the Securities and Exchange Commission, H.R. Rep. No.95, 88 th Cong., 1 st Sess., pt. 2, at 247 (1963), as cited in Macey, Mitchell and Netter (1989). 5 Prior to that the NYSE had a prohibition (introduced in 1931) on short sales at a price lower than the previous sale; in 1932 the NYSE required all brokers too obtain written authorization from their customers before lending their shares. 6 These reforms included, for example, requiring short sellers in all equity securities to locate securities to borrow before selling. They also include additional delivery requirements on broker-dealers for securities in which a substantial number of failures to deliver have occurred. CMCRC Literature Review Short Selling Page 9 of 30

10 Table 1: Summary of industry feedback on the proposed US short selling regulatory reforms Issue Should short sale restrictions be suspended in advancing markets? Should short sale restrictions be suspended when the security or market is above a threshold price? Should securities with active daily trading volumes be exempted from the short sale rule? Should the short sale restrictions focus on specific market events such as certain trading strategies or market events such as mergers, acquisition, tender offer, or option's expiration dates, or the opening and close of trading? Should short sales restrictions also be applied to after-hours trading? Is the uptick rule effective under the decimalization system? Should short sales regulation also be applied to non-exchange listed securities? Industry Feedback Many industry participants felt that it was unnecessary to have short sale restrictions in advancing markets. Mixed response. Some favored this, with two respondents suggesting that the short sales rule should only apply if a stock falls 5-10% below the previous close. However, others felt that this would not make a significant difference and would make the regulation too complicated. Mixed response. Some felt yes, as securities with high daily volume and high public float would be more difficult to manipulate than less liquid securities. Others opposed the exception. Most opposed the concept of focusing restrictions on specific market events. However, most broker-dealers favored an exception for hedging transactions, arguing that short sales as hedges are not intended to drive down a securities price because they result in economically neutral positions. Most respondents favored the application of the restrictions in after-hours trading. Many respondents suggested that the minimum price variation of 1 cent may render the tick rule insignificant. Most respondents favored extending the regulation to nonexchange listed securities. Source: Adapted from Summary of Comments, SEC Concept Release: Short Sales, Release No (October 20, 1999), File No. S Price restrictions on short selling in other markets A comprehensive summary of short selling regulations in 111 countries summarized by Charoenrook and Daouk (2005) is reproduced in Appendix 1. It can be seen that every developed market in their list except for Singapore allows short selling (albeit under varying degrees of freedom). 7 European markets in general tend to be more liberal and less prescriptive in the regulation of short selling, with some (such as the 7 The Singapore Exchange (SGX) administers its own Securities Lending Programme through its central depository (CDP). The CDP acts as counterparty to both lenders and borrowers, and lends eligible securities to registered investors according to demand. CMCRC Literature Review Short Selling Page 10 of 30

11 Switzerland, Ireland and Denmark having no specific rules on short selling. The London and Tokyo stock exchanges have no price restrictions on short selling. Some countries such as Australia, Hong Kong, Singapore and New Zealand have periodically-updated lists of approved securities that can be short sold. These securities are usually picked based on various criteria such as the security s liquidity and market capitalization. Hong Kong also has a tick rule which only allows shorting at or above the best current ask price. 8 Most of the developing markets surveyed by Charoenrook and Daouk (2005) do not allow short selling, although a few such as Chile are actively promoting it through various means such as tax concessions and liberalizing their rules to allow short selling. Some of the markets in this category do allow short selling with restrictions, such as Taiwan which allows short selling if the price is not lower than the previous day s closing price, and Iceland which allows short selling only for mutual funds. 8 This rule was introduced at the inception of regulated short selling in January 1994, but abolished in March It was subsequently reintroduced in September 1998 during the height of the East Asian financial crisis. HKEX plans to discuss the proposed removal of the tick rule with the SFC in CMCRC Literature Review Short Selling Page 11 of 30

12 3. Review of the literature on short selling Short sales have in the past been commonly criticised for exacerbating market declines, and facilitating the manipulation of share prices. Bear raids were argued to have precipitated the stock price declines in the 1920s: speculators sell short, spread false rumours about the company to drive down the price of the company s shares, and then buy back the shares to cover their short positions. Short selling has also been cited as a factor exacerbating market volatility, and in facilitating the program trading that intensified the lead-up to the stock market crash of October On the other hand, short selling is also widely regarded as beneficial to the markets in terms of improved liquidity and pricing efficiency. This view is substantiated by a strong body of empirical research. Short selling promotes the informational efficiency of share prices by facilitating the incorporation of negative information or expectations, thus preventing the overpricing of stocks. Short selling facilitates arbitrage and hedging, which in turn enables institutional investors to take on larger positions at reduced risk. This is argued to enhance overall market liquidity, although the empirical evidence for this is mixed. Short selling also facilitates the more efficient use of assets; some institutional investors may choose (or may be compelled by their investment mandates) to keep a large inventory of shares in their portfolio. They can increase their effective returns on these assets by lending these shares to other investors for a given return on the collateral deposited, net of the rebate rate or repo rate. The stock borrowers in turn attempt to make a profit by short selling what they believe are overvalued stocks. However, problems may arise when such short selling overcorrects the security s market price, or where a short seller attempts to manipulate the market price by short selling the security, consequently exhausting all liquidity available at the bid side and forcing the price down. Such effects may be exacerbated in illiquid stocks, and where short sales by bear raiders may be misinterpreted by other investors as being informed short sales and thus precipitate widespread downward revaluations of that stock. The systemic stability of the financial system is also at risk when short sellers engage in naked shorts which could result in a delivery failure. Indeed, concerns over naked shorting masquerading as routine fails to deliver were cited as among the main reasons for the introduction of Regulation SHO in the US. Such issues are critical to regulators in discharging their mandate to maintain market efficiency and integrity. It is thus important to understand the practical effects of current short selling restrictions, who is affected by these restrictions, in what manner they are affected, and the effectiveness of these restrictions in achieving the desired regulatory objectives. The following sections review the various theories and corresponding empirical evidence on the role of short selling price restrictions in price discovery, arresting destabilizing market declines, and in preventing bear raids and similar manipulative behavior. Particular emphasis is paid to the policy implications for regulators. A more comprehensive summary of the relevant literature is set out in Appendix Price discovery and market volatility Short selling is, at its very fundamental level, meant to facilitate efficient price discovery. It is essentially an arbitrage tool; and if there are impediments to arbitrage, it is possible for securities to become overpriced. Figlewski (1981) argues that stocks with severe short sales constraints are priced with an upward bias because those with a pessimistic view of the stock (and who do not already own it) are restricted from acting on their pessimistic beliefs by engaging in short selling. It is generally recognized that if short selling is costly to execute then uninformed or liquidity traders will tend to avoid doing so. Informed investors with strong negative information will be more likely to engage CMCRC Literature Review Short Selling Page 12 of 30

13 in short selling. Diamond and Verrecchia (1987) was the first study to model the effect of shorting restrictions on bid-ask spreads, price adjustment and other measures of transactions costs and price discovery. Their model is premised on the concept that rational investors, upon knowing that a particular security has a high level of short interest, take this as a signal that the stock is overvalued and the price needs downward adjustment. Their model posits that short sale restrictions can make prices respond more slowly to news, particularly bad news. By reducing the speed of price adjustment and reducing the amount of information impounded in the security s price at any point in time, they argue that short sale restrictions increase the price reaction when private news is made public, and this increases the stock price s volatility. 9 Such restrictions consequently induce market makers to set wider bid-ask spreads in order to protect themselves from these effects. Many studies support the hypothesis that short sale restrictions impede price discovery by causing securities to be overpriced because investors cannot trade freely on their negative views (see, for example, Aitken, Frino, McCorry and Swan (1998), Jones and Lamont (2002) and Jones (2003)). Chang and Yu (2004) find that short-sales constraints in the Hong Kong stock market tend to cause stock overvaluation, which is greater for individual stocks where a wider dispersion of investor opinions exists. They suggest that eliminating short-sales restrictions will help improve the efficiency of price discovery. Similarly for the Canadian stock market, Ackert and Athanassakos (2005) find that short sales volumes are negatively correlated with excess returns, consistent with the overpricing hypothesis. This effect is more pronounced for small firms with more constraints on the supply of shortable securities, and less pronounced for stocks with associated options and convertible bonds. The study also finds evidence consistent with the proposition that informed traders short sell dual-listed Canadian stocks in Canada rather than in the US, to take advantage of lower execution costs. The authors argue that, based on these results, market efficiency would be improved by less restrictive regulation of short sales. When short positions are difficult to establish due to regulatory restrictions, there is a heightened risk of markets or portfolios being overpriced with no smooth recourse for correction or arbitrage. Mitchell, Pulvino and Stafford (2002), Lamont and Thaler (2003), and Ofek and Richardson (2003) found this to have contributed to the dotcom bubble of the late 1990s and early 2000s, while Pontiff (1996) arrived at a similar conclusion for the closed-end fund industry. In terms of liquidity, Jones (2003) found that bid-ask spreads actually improved with the introduction of the tick restrictions in the US. One explanation offered for this was that the tick restrictions force shorts to use less aggressive limit orders instead of market orders. Thus, the uptick rule prevents shorts from aggressively demanding liquidity, making them instead more likely to supply liquidity to the market, which in turn reduces spreads Preventing the exacerbation of market declines Tick rules are typically aimed at addressing widely held concerns that untrammeled short selling will exacerbate price declines in a falling market. Miller (1977) describes stock lending and short selling as analogous with increasing the supply of available stock: short selling increases the supply of outstanding 9 While there is a counter-argument that short selling restrictions help slow down sharp price declines and allow investors to take a breather and assess the situation more calmly, such arguments are usually reserved for market-wide declines and addressed through circuit breaker mechanisms. Price restrictions on short selling are not typically designed to address this specific purpose but rather to prevent manipulation driving share prices down. 10 However, his study utilized daily closing data, so a finer level of aggregation such as intraday data would be beneficial in shedding light on the behavior of bid-ask spreads during this period. CMCRC Literature Review Short Selling Page 13 of 30

14 stock, thus forcing its price down over as the volume of shorting increases. He notes that in reality, though, short selling restrictions mean that actual short positions are usually only a small fraction of total outstanding shares, so such a dampening effect is likely to be small, if any. Most of the empirical literature on the effects of price restrictions on short selling has tended to focus on the US markets and generally yielded little compelling evidence that the uptick rule promotes stability in declining markets. What the empirical studies do show, almost overwhelmingly, is that short selling is not practiced by a wide number of investors even in the most highly capitalized and liquid markets. Although some 93% of the world s equity is shortable (Bris, Goetzmann and Zhu (2004)), in practice most studies find that short selling is rare and the amount of shares short sold is small, and typically less than 1% of total shares outstanding over the wide range of sample periods studied. 11 Nevertheless, even if short selling is not widespread, can concerns that heightened short selling exacerbates market declines be empirically substantiated? The extant literature on this is not wide, but generally suggests that the answer is no. Albert Jr., Smaby and Robison (1997), for example, find that short selling in NASDAQ SmallCap stocks during a period when it was not subject to an uptick rule or effective prohibitions against naked short selling did not destabilize markets by exacerbating price declines amidst falling markets. Interestingly, Alexander and Peterson (1999) find that the execution quality of short-sell orders on the NYSE is adversely affected by the uptick rule, even when stocks are trading in advancing markets. Clearly, this is inconsistent with one of the three stated objectives of the rule, i.e., to allow relatively unrestricted short selling when a firm s stock is advancing so that the rule does not affect price discovery during such times. The evidence on the effect of short selling constraints on capital raising, volatility and returns distributions is mixed. Miller (1977) notes that short selling restrictions may make equity financing easier (by reducing the possibility of an increased supply of stock after the offering), although possibly at the cost of greater price volatility and poorer price discovery, particularly for speculative securities. 12 Chang and Yu (2004) find that when short sale constraints in Hong Kong market are removed, individual stock returns exhibit higher volatility but less positive skewness. However, Charoenrook and Daouk (2005) in their study of 111 global markets find no evidence that short-sale restrictions affect either the level of skewness of returns or the probability of a market crash. 3.3 Preventing bear raids and market manipulation There is relatively little comparative literature on the role of the tick rule in preventing market manipulation beyond the US markets. Ferri, Christophe and Angel (2004) argue that the uptick rule and bid test are unnecessary in the US for preventing bear raids and market manipulation. They compare the frequency and association of short selling with rapid price declines on Nasdaq NMS stocks and Nasdaq SmallCap stocks, and find that there is actually less short selling for the SmallCap stocks which are not subject to the bid test, and that these stocks are also not more correlated with price declines than their matching NMS stocks. The authors conclude that the restrictions and disclosure requirements already in place, coupled with the 11 See Figlewski and Webb (1993), Dechow, Hutton, Meulbroek and Sloan (2001), Jones and Lamont (2002), and Angel, Christophe and Ferri (2003). 12 He stops short, however, of explaining this argument in further detail. CMCRC Literature Review Short Selling Page 14 of 30

15 improved availability of information to market participants, already make it much more difficult for manipulators to pull off a bear raid successfully than in the past at the time the uptick rule was devised. 13 One of the main caveats in extrapolating the results of this research, however, is that the short selling in the US is among the most tightly regulated among developed markets. Even under Regulation SHO s pilot program, the designated securities are still subject to other restrictions on short selling including statutory margin requirements, and the location requirement. Also, it should be noted that tick sizes in the US have changed considerably since the 1930s when the uptick rule was devised. At that time the minimum tick on the NYSE was 1/8 of a dollar, compared with US$0.01 or less at the current time. Therefore, the price change required for an uptick trade is now considerably smaller. The reduced tick size is likely to give rise to more movements in the bid and ask prices and therefore more opportunity for trading on an uptick. In Canada, the current minimum bid for securities trading at or above $0.50 is $0.01, while the minimum bid for securities trading below $0.50 is $ The small tick size potentially makes it relatively easy for short sellers to fulfill the zero tick rule, by using a small trade to create a zero tick or uptick before executing a large short sell order. In short, it can be seen that the costs of executing a short sale in Canada are presently already much lower than in the US. There is no uptick rule (the zero tick rule is less restrictive), shares do not have to be borrowed before they are sold short, and the margin requirements for stocks with associated options are generally lower in Canada. Ackert and Athanassakos (2005) argue that investors in the Canadian market can respond more quickly to news because, unlike in the US, there is no requirement to locate or borrow the shares prior to shorting them. 14 Furthermore, the long list of exemptions from the tick rule makes the parameters delineating the application of the rule fairly wide. Logically, it can be argued that the longer the list of exemptions, the more avenues for circumvention of the uptick rule. Ackert and Athanassakos (2005) argue that market efficiency will benefit further from the removal of the zero tick rule. However, given that the tick rule presently stands as the main regulatory instrument of protection against potential manipulative short selling, care should be taken with regard to its wholescale removal. As already noted, the costs of executing a short sale in Canada are presently already much lower than in the US. Further study should be made of whether the zero tick rule has, in practice, played a role in preventing or mitigating market manipulation. Such an examination may include, for example, looking at the pattern of short sale orders on an intraday basis and their effect on the bid-ask spread, price and volume of individual securities. It may also involve an assessment of the incidence of short selling in market manipulation cases investigated by RS. It is nevertheless recognized that the tick rule cannot be the sole means of preventing market manipulation and bear raids. Indeed, even a 1963 SEC study found that, in a declining market, upticks occurred often enough to allow nimble short sellers to execute significant short sales (Worley (1990)). Another point to be noted is that some instruments and activities such as exchange-traded funds, program trading and market making activities are already exempt from the zero tick rule. As also noted by RS roundtable participants, manipulative behavior could manifest through uptick trading by manipulating the price of a security upwards with purchases of the security. Consideration should thus also be given to other means of addressing market manipulation concerns beyond the tick rule. 13 It should be noted that these results may also arise if Nasdaq SmallCap stocks are harder to borrow than NMS ones: a line of argument that the authors did not examine empirically. 14 Although it is noted that some brokers require investors to confirm their ability to borrow the stocks, particularly low-priced or illiquid ones, before entering a short sale. CMCRC Literature Review Short Selling Page 15 of 30

16 4. Conclusion The fundamental question in regulating short selling is: what is the objective of such regulation? Concerns about short sale abuses primarily revolved around the exertion of downward pressure in a falling exchange market. Indeed, the US 1938 uptick rule was specifically designed to address this concern. We can generally identify the typical objectives for short selling restrictions as preventing market manipulation, preventing the escalation of disorderly markets and mitigating the demoralizing effect of short selling on the market. However, these objectives are not always of equal importance to all regulators; for instance, while the prevention of manipulation is a fundamental concern to all regulators, not all may be equally concerned with slowing down the speed of price adjustment to arrest a market decline accelerated by short selling. Also, these objectives are necessarily intertwined. Manipulative short selling may motivate even more selling on both the long and short sides, thus creating a spiralling downward effect depressing sentiment further. If RS s primary objective is not as much to prevent such a dampening effect on market sentiment as to prevent market manipulation through short selling, it is pertinent to ask if the tick test is the optimal means of achieving this. In asking this question, it is also necessary to consider that the zero tick rule is the primary short selling restriction in Canada, unlike in markets such as the US which have multiple short selling restrictions enshrined in legislation and administered by multiple statutory agencies. Having decided on the main regulatory objectives in relation to short selling, RS would need to address the following questions: (i) Has the zero tick rule been effective in curbing market manipulation through short selling, and any other primary reasons for the rule? (ii) What other measures can be taken to prevent short sellers from driving down share prices? (iii) What have been the costs and benefits of the zero tick rule in the Canadian securities market, and who reaps these costs and benefits? The indiscriminate nature of the existing zero tick rule means that all securities, regardless of their liquidity (even though more liquid securities are more difficult to manipulate), or their borrowing availability (even though securities that are more difficult to borrow may be involved in more failures to deliver by short sellers) are equally affected by the rule. 15 One option to address this could be to adopt a tiered system in which more liquid and easily-available stocks are exempted from the tick rule under a pilot program. Another could be to examine alternative means of constraining short selling, such as margin or location requirements, that would meet the market integrity objectives of the regulator without unduly constraining price discovery or liquidity. Clearly, short sale restrictions interfere with the perfectly free transmission of information through stock prices. How important this is must be weighed against the potential benefits of the tick rule in mitigating destabilizing price declines and bear raids. This, however, can only be assessed following more in-depth study of the role the tick rule has played in this in the Canadian securities market. 15 Market Regulation Services Inc., Market Integrity Notice No , July CMCRC Literature Review Short Selling Page 16 of 30

17 Based on the existing evidence on the role of the tick rule in the Canadian as well as global securities markets, it would appear that there is a case for its removal if the primary objective is to prevent market manipulation. It is recommended that, as part of its decision-making process on whether to remove the zero tick rule, RS closely examines the role of the existing price restrictions in the price discovery process in the Canadian securities market. This should include an examination of other aspects of market quality such as execution quality, liquidity and volatility. It should also examine the historical magnitude of, and trends in, short selling in the Canadian securities market, the extent to which short selling has played a role in market manipulation cases initiated by RS, the extent to which such activity can be carried out within the confines of the tick rule and existing exemptions, and the potential implications of removing the rule for market quality and investor protection. At the same time, RS may wish to consider a closer examination of the process by which it can more effectively monitor the non-disclosure of short sales by participants intending to manipulate the market. This will facilitate the ongoing surveillance of short selling activity, which will be critical to market confidence particularly if the price restrictions are eventually removed. CMCRC Literature Review Short Selling Page 17 of 30

18 References Ackert, L. F., and G. Athanassakos, 2005, The relationship between short interest and stock returns in the Canadian market, Journal of Banking & Finance 29, Aitken, M. J., A. Frino, M. S. McCorry, and P. L. Swan, 1998, Short sales are almost instantaneously bad news: Evidence from the Australian stock exchange, The Journal of Finance 53, Albert Jr., R. L., T. R. Smaby, and H. D. Robison, 1997, Short selling and trading abuses on Nasdaq, Financial Services Review 6, Alexander, G. J, and M. A. Peterson, 1999, Short Selling on the New York Stock Exchange and the Effects of the Uptick Rule, Journal Of Financial Intermediation 8, Angel, J. J., S. Christophe, and M. G. Ferri, 2003, A Close Look at Short Selling on Nasdaq, Financial Analysts Journal 59, Bris, A., W. N. Goetzmann, and N. Zhu, 2003, Short-Sales in Global Perspective, Yale ICF Working Paper No Bris, Arturo, W Goetzmann, and Zhu, 2004, Efficiency and the Bear: Short Sales and Markets around the World, Working Paper, Yale University. Chang, Eric, and Yinghui Yu, 2004, Short-Sales Constraints and Price Discovery: Evidence from the Hong Kong Market, Working Paper, University of Hong Kong. Charoenrook, A., and H. Daouk, 2005, A Study of Market-Wide Short-Selling Restrictions., Dechow, Patricia, Amy Hutton, Lisa Meulbroek, and Richard Sloan, 2001, Short-sellers, fundamental analysis, and stock returns, Journal of Financial Economics 61, Diamond, Douglas W., and Robert E. Verrecchia, 1987, Constraints on Short-Selling and Asset Price Adjustment to Private Information, Journal of Financial Economics 18, Ferri, M. G., S. Christophe, and J. J. Angel, 2004, A Short Look at Bear Raids: Testing the Bid Test, Working Paper, Georgetown University and George Mason University. Figlewski, S., 1981, The Informational Effects of Restrictions on Short Sales: Some Empirical Evidence, Journal of Financial and Quantitative Analysis 16, Figlewski, S., and G. Webb, 1993, Options, Short Sales, and Market Completeness, Journal of Finance 48, Geczy, Christopher C, David K Musto, and Adam V Reed, 2002, Stocks are special too: An analysis of the equity lending market, Journal of Financial Economics 66, 241. Jones, C. M., 2003, Shorting restrictions, liquidity and returns, Working Paper, Graduate School of Busineses, Columbia University and the NYSE. Jones, Charles M., and Owen A. Lamont, 2002, Short-sale constraints and stock returns, Journal of Financial Economics 66, Lamont, O. A., 2004, Go down fighting: short sellers versus firms, Working Paper, Yale School of Management. Lamont, O. A., and R. H. Thaler, 2003, Can the market add and subtract? Mispricing in tech stock carveouts, Journal of Political Economy 111, CMCRC Literature Review Short Selling Page 18 of 30

19 Macey, J. R., M. Mitchell, and J. Netter, 1989, Restrictions on short sales: An analysis of the uptick rule and its role in view of the October 1987 stock market crash, Cornell Law Review 74, Miller, E., 1977, Risk, uncertainty and divergence of options, Journal of Finance 32, Mitchell, M., T. Pulvino, and E. Stafford, 2002, Limited arbitrage in equity markets, Journal of Finance 57, Ofek, E., and M. Richardson, 2003, DotCom mania: a survey of market efficiency in the internet sector, Journal of Finance 58, Pontiff, J., 1996, Costly arbitrage: evidence from closed-end funds, Quarterly Journal of Economics 111, Worley, D. C., 1990, The regulation of short sales: The long and short of it, Brooklyn Law Review 55, CMCRC Literature Review Short Selling Page 19 of 30

20 Appendix 1 Short selling provisions in global markets The information reported here reflects regulation and practice in 111 countries surveyed by Charoenrook and Daouk (2005). The Legality column represents the year short selling became legal in each country. A "Yes" means that short selling has always been legal for the period from post-wwii to A "No" means that short selling has always been prohibited. The Feasibility column represents the year short selling became practically feasible in each country. A "Yes" means that short selling has always been feasible. A "No" means that short selling has never been feasible. CMCRC Literature Review Short Selling Page 20 of 30

21 CMCRC Literature Review Short Selling Page 21 of 30

22 CMCRC Literature Review Short Selling Page 22 of 30

23 Source: Charoenrook and Daouk (2005) United States The SEC deals with short selling under the following rules in The Securities Exchange Act of 1934: Rule 3b-3: Noted above, defines a short sale. The rule also clarifies ownership of a security, since short sellers do not own the security they are selling. A short sale, as defined in Rule 3b-3 of the Securities Exchange Act of 1934, refers to any sale of a security which the seller does not own, or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller. The security is borrowed from the brokerage firm, and all short sales must be done in a margin account. Customers must identify a sale as short at the time the order is placed with the broker. Conversely, a customer who owns a security outright is considered long that security. Selling a long position in a security, in whole or in part, will not result in a short position. Rule 10a-1: This rule states that short sales may only be done on a plus tick, or on a zero-plus tick. They may not be done on a minus tick, or on a zero-minus tick. The rule is in place to prevent market manipulation and prevent short sales from driving the price of a security down. When a stock goes ex-dividend and the price of the stock is adjusted accordingly, the tick rule will apply to that adjusted price. 16 The information in this rule is exactly the same as in NYSE Rule 440B. In general, the NYSE Rules governing margin and short sales include: Rule 431: This deals with margin requirements, initial margin, maintenance margin, additional margin, exceptions, and definitions. 16 Note, however, that securities that are purchased on margin (not sold short), do NOT have this restriction. They can be bought regardless of the prevailing tick. CMCRC Literature Review Short Selling Page 23 of 30

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