Restricting Short Selling Raises Default Risks

Looser regulations, cheaper credit
When the SEC loosened short-selling restrictions for a random group of stocks, the companies’ credit-default-swap spreads became lower than those linked to companies that were not part of the SEC program.

 

Maffett and Owens, 2017

Maffett and Owens looked at the market for credit-default swaps, financial agreements that protect buyers from default risk in return for a payment stream known as the spread. CDS spreads reflect the likelihood, according to the market, that a company will default.

The researchers find that companies in the SEC program had lower CDS spreads, meaning that credit prices were lower. Companies with fewer short-selling restrictions had spreads that were priced around two-thirds of a percentage point below those of companies not in the program.

The researchers also studied short-selling bans imposed around the globe, examining country-by-country differences in the proportion of a company’s shares that are borrowed relative to market capitalization. They find that more extensive short-selling constraints were correlated with higher CDS spreads. During the periods studied, stocks that were exposed to a ban had CDS spreads significantly higher than at companies not affected by a ban.

Taken together, the analyses by Maffett and Owens suggest that trading restrictions in the form of limits on short selling lead to higher credit prices. “Our evidence suggests that short-selling constraints not only keep public information out of equity prices, but also reduce the incentive to acquire private information,” Maffett and Owens write. Investors and market participants pay more as a result.