Can we expect more to come?
Now that the restriction on short selling has come and gone, we examine the effect it had on the market. Given that the market has deteriorated further, it is possible that there will be further regulatory changes related to short selling. In this report we extend our earlier analysis (What Happened When Traders’ Shorts Were Pulled Down, 30 Sept 2008) of the impact the latest rules have had on liquidity, costs and volatility. We also highlight the effect of the restriction on the related futures and ETF markets.

Selling pressure comes from long sellers
If short sellers are indeed to blame for pushing down prices, as many contend, we should have seen a reprieve during the period when short selling was restricted. Returns indicate that, in fact, this was not the case. Specifically:

• Prior to the restriction, restricted stocks actually performed better than the market. If short sellers had targeted these stocks, we would expect to see them sell off more than the market while short selling was still allowed
  
• The market dropped far more after the restriction was put in place than before
  
• Stocks subject to the short sell restriction fell along with the rest of the market during the restriction period. This selling was caused entirely by people who already owned the stocks and wanted to get out (“long sellers”) rather than short sellers (see Fig.1).

Following the short sell restriction, we witnessed a dramatic drop-off in volume. Lower activity is harmful as it makes it more costly to trade by increasing the bid-ask spread.