Stock markets have done well this week, the world over. The US markets were up about 6%, at the time of writing, while key European markets were up 5-7%. Most Asian markets rose, too, although India is a bit of an outlier with a drop of 5% in the Nifty 50 so far this week.

Of course, there are concerns among investors about the impact of the lockdown on India’s economy.

But also note that the Indian capital market regulator imposed some curbs on short- selling, starting this week. It’s interesting that the Indian market is down, when most other markets are up. Could it be that the curbs have backfired?

“Short-selling curbs are a double-edged sword. If they create the impression that the market is being artificially propped up, then those who want to bottom-fish will tend to stay away, on the premise that prices haven’t yet fallen to their true levels. This can result in the lack of buying support when stocks are falling," said Jayanth R. Varma, professor at Indian Institute of Management Ahmedabad, who primarily works on financial markets and their regulation.

Policy misfire
Policy misfire

During the global financial crisis of 2008, the US Securities Exchange Commission (SEC) had banned short-selling in financial stocks. About three months after the ban, SEC chairman Christopher Cox told Reuters: “Knowing what we know now, I believe on balance the commission would not do it again… The costs (of the short-selling ban on financials) appear to outweigh the benefits."

Academic research prior to the crisis had already cast doubts on the benefits of short-selling curbs. And, in fact, India had done well to resist the call for curbs soon after the Lehmann Brothers’ collapse.

Studies on the curbs during the financial crisis had cast further doubts about the effectiveness of short-selling bans and curbs. A paper by Alessandro Beber and Marco Pagano of the Centre for Economic Policy Research said the bans and regulatory constraints on short-selling during the financial crisis were detrimental for market liquidity and slowed price discovery.

“The ban-induced decrease in market liquidity is especially serious because it came at a time when bid-ask spreads were already high as a result of the crisis and investors were desperately seeking liquid security markets because of the freeze in many fixed-income markets," wrote the researchers in a paper published in The Journal of Finance.

“Our estimates...suggest that the ban of naked short sales is associated with lower returns for non-US countries," they added.

Given the plethora of research on the subject, it’s odd that the Securities and Exchange Board of India (Sebi) gave up its rich tradition of letting markets function freely and gave in to demands for curbs on short-selling. The initial response of the markets clearly suggested it took the wrong call.

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