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Menachem Brenner and Marti G. Subrahmanyam
Until the current global financial crisis, the practice of selling shares that one did not own, known as short-selling, was generally permitted in most countries. Of course, there were some restrictions placed on such transactions, such as the need to borrow the stock prior to the sale ("no naked shorts"), selling at a higher price than the previous trade ("the uptick rule") and disallowing short-selling to capture gains and postpone tax payments ("no shorting against the box").
In a dramatic decision in the early weeks of the current crisis, the SEC banned short-sales of shares of 799 companies on September 18 and lifted the ban on October 8, this year. However, most countries around the globe, and in particular, the U.K. and Japan, which are homes to the two other major financial centers, London and Tokyo, have declared a ban on short selling for “as long as it takes” to stabilize the markets. Even in the U.S., there is continuing pressure on the regulators to reinstate the ban, at least in selected securities.
The immediate policy issues are as follows:
Should there be any restrictions on short selling equity shares of individual companies, if not a total ban on such transactions?
If so, what specific restrictions should be instituted, and under what circumstances should they be enforced by the regulators?
What is the appropriate framework for timely reporting of short interest and/or short sales to ensure transparency of these transactions to the market?
A highly desirable feature of financial markets is that they be fair to all participants who wish to trade. An aspect of this fairness is that these markets operate in a transparent manner, making available information to all participants at the same time, so that the markets can be efficient. In efficient financial markets, the prices of financial assets reflect all available information - favorable and unfavorable - that may affect the magnitude and the risk of future cash flows from these assets. For markets to be efficient, we need to allow for the unimpeded flow of such information and the unfettered actions of all participants in the markets. Along the same lines, an important tenet of adequate regulation and taxation of financial markets is the symmetrical treatment of buyers and sellers of financial assets. This symmetrical approach should always prevail, as an Occam’s razor, in normal times and during a crisis, so that neither party has an unfair advantage. Exceptions to this principle ought to be few and far between.
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