Published On: Wed, Oct 26th, 2016

Experts Claim that Short-Selling Did Not Cause the Financial Crash

For a long time, short-selling was held responsible for the financial crash of 2008. In the eyes of many, it was culpable beyond doubt, with aggressive trades charged with costing investors $1 billion, driving around 1,000 companies into the ground and sending the markets into chaos.

In 2015, a Warwick Business School study was the first to suggest otherwise. They claimed that traders who ‘failed to deliver’ on stock market moves were not guilty of causing the collapse of major names like AIG, Lehman Brothers, and Bear Stearns.

Here, we try to unravel the truth behind the myth…

Claims of Blame Called into Question

Following the crash of 2008, the U.S. Securities and Exchange Commission (SEC) were quick to introduce a ban on aggressive short-selling. They held the practice largely culpable for the collapse of Lehman Brothers, the country’s fourth largest investment bank, as well as the loss of over $1 billion and 1,000 companies.

Yet a study by Warwick Business School calls such claims into doubt. The research found that there was no evidence of FTDs casing the failure of financial firms, and that the spike in their number succeeded, rather than preceded, Lehman Brothers and others stating that they were facing difficulties.

The reason that FTDs are relevant to the culpability of short-selling is because they occur due to a practice known as ‘naked short-selling’, which is when a short seller gambles that a stock’s price will fall without borrowing the shares before selling them, or attempting to cover their position post-sale. This can leave them unable to afford the shares, and can mean that they are unavailable three days after sale. Thus, the position on the stock cannot be covered.

According to Dr Raman, who led the study: “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.”

A Lack of Evidence

Furthermore, there was not only a lack of correlation between an increase in FTDs and the financial difficulty of firms, but also no evidence was found to suggest that FTDs had a detrimental effect on stock markets, nor that they could cause price distortions.

In fact, when FTDs increased, there was actually a beneficial impact on the markets. Liquidity and pricing efficiency tended to improve on days following large FTD changes, and there was a reduction in pricing errors, intraday volatility, spreads, and order imbalances.

Importantly, the Warwick Business School research demonstrated that despite the measures implemented by SEC to reduce FTDs, the intended effect failed to materialise, and they actually had a detrimental impact on liquidity. In addition, significant increases in pricing errors, relative bid-ask spreads, and intraday volatility were seen.

As Dr Raman explains: “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, and FTDs are doing the same.

He finished: “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.”

Although the topic of short-selling remains controversial, this argument has undeniable merit. If we were asked our opinion on whether or not it had in fact contributed to the financial crash, our answer would be a resounding ‘no’. Risky it may be, but responsible for all of the failings of the markets it is not.

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About the Author

- Robert is a private trader with over 15 years experience trading the financial markets.