We aim to tackle the longstanding debate on whether stock liquidity enhances or impedes firm innovation. This topic is of interest because innovation is crucial for firm‐ and national‐level competitiveness and stock liquidity can be altered by financial market regulations. Using a difference‐in‐differences approach that relies on the exogenous variation in liquidity generated by regulatory changes, we find that an increase in liquidity causes a reduction in future innovation. We identify two possible mechanisms through which liquidity impedes innovation: increased exposure to hostile takeovers and higher presence of institutional investors who do not actively gather information or monitor.

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During 2005 to 2007, the SEC ordered a pilot program in which one-third of the Russell 3000 index were arbitrarily chosen as pilot stocks and exempted from shortsale price tests. Pilot firms' discretionary accruals and likelihood of marginally beating earnings targets decrease during this period, and revert to pre-experiment levels when the program ends. After the program starts, pilot firms are more likely to be caught for fraud initiated before the program, and their stock returns better incorporate earnings information. These results indicate that short selling, or its prospect, curbs earnings management, helps detect fraud, and improves price efficiency. PREVIOUS RESEARCH SHOWS that short sellers can identify earnings manipulation and fraud before they are publicly revealed. 1 But this is for earnings manipulation that has already taken place. Might short selling also constrain firms' incentives to manipulate or misrepresent earnings in the first place? That is, does the prospect of short selling help improve the quality of firms' financial reporting?In this paper we exploit a randomized experiment that allows us to address this question. In July 2004, the Securities and Exchange Commission (SEC) adopted a new regulation governing short-selling activities in the U.S. equity markets-Regulation SHO. Regulation SHO contained a Rule 202T pilot program in which stocks in the Russell 3000 index were ranked by trading volume * Fang is with the University of Minnesota. Huang is with the Hong Kong University of Science and Technology. Karpoff is with the University of Washington. We are grateful for helpful comments from two anonymous referees, an anonymous Associate Editor, Kenneth Singleton (the Editor), Vikas pilot stocks were exempted from shortsale price tests, including the tick test for exchange-listed stocks and the bid test for NASDAQ National Market (NASDAQ-NM) stocks. 2 The pilot program creates an ideal setting to examine the effect of short selling on corporate financial reporting decisions, for three reasons. First, the exemption from short-sale price tests decreased the cost of short selling in the pilot stocks relative to the nonpilot stocks (SEC (2007), Diether, Lee, and Werner (2009)). The pilot program thus eliminates the need to directly estimate short-selling costs, a notoriously difficult task (Lamont (2012)). Rather, we use the fact that the prospect of short selling increased for pilot firms relative to nonpilot firms during the program. Second, the pilot program represents a truly exogenous shock to the cost of selling short in the affected firms. We identify no evidence that the firms themselves lobbied for the pilot program, or that any individual firm could know it would be in the pilot group until the program was announced. Third, the pilot program had specific beginning and ending dates, facilitating difference-in-differences (hereafter, DiD) analysis of the impact of short-selling costs on firms' financial reporting. In particular, the anticipated ending date allows us to investigate w...

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