Working Paper: CEPR ID: DP17725
Authors: Caroline Fohlin; Zhikun Lu; Nan Zhou
Abstract: In theory, banning short selling stabilizes stock prices but undermines pricing efficiency and has ambiguous impacts on market liquidity. Empirical studies find mixed and conflicting results. This paper leverages cross-country policy variation during the 2020 Covid crisis to assess differential impacts of bans on stock liquidity, prices, and volatility. Results suggest that bans improved liquidity and stabilized prices for illiquid stocks but temporarily diminished liquidity for highly liquid stocks. The findings support theories in which short sale bans may improve liquidity by selectively filtering out informed—potentially predatory—traders. Thus, policies that target the most illiquid stocks may deliver better overall market quality than uniform short sale bans imposed on all stocks.
Keywords: COVID-19; Pandemic; Financial Market Microstructure; Liquidity
JEL Codes: G01; G12; G14; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| short sale bans (G21) | improved liquidity for illiquid stocks (G14) |
| short sale bans (G21) | stabilized prices for illiquid stocks (G19) |
| short sale bans (G21) | filtered out informed traders (G14) |
| short sale bans (G21) | decreased relative spread for high-spread stocks (C46) |
| positive effects of bans on illiquid stocks (G18) | persisted after lifting of bans (P33) |
| negative effects of bans on liquid stocks (G18) | dissipated after lifting of bans (Y40) |
| short sale bans (G21) | diminished liquidity for highly liquid stocks (G19) |
| increased order processing costs (C69) | diminished liquidity for highly liquid stocks (G19) |