Flying Under the Radar: The Effects of Short-Sale Disclosure Rules on Investor Behavior and Stock Prices

Abstract

Reproduction permitted only if source is stated.ISBN 978-3-95729-275-9 (Printversion) Non-technical summary Research Question "Going short", the selling of a security that is not currently owned, and subsequently repurchasing it, is a common practice in financial markets. Controversial in society at large, short sellers play a major role in financial theory. Moreover, there is ample evidence that short selling, in general, contributes to market efficiency, enhances liquidity, and facilitates risk management. However, there has been intense debate, among academia, regulators, and the general public, that the practices of short sellers remain largely in the dark. Unlike long positions, which in most countries are governed by various disclosure rules, short positions have not been subject to such disclosure requirements hitherto. Proponents of short-selling disclosure rules argue that greater transparency increases the efficiency and fairness of financial markets. However, public disclosures may pose a threat to proprietary investment strategies and may harm the interests of short sellers. As a consequence, a disclosure rule could affect the trading behavior of investors and the efficiency of security prices. These questions lie at the heart of the debate on introducing a disclosure obligation for short sellers and have yet to be answered. ContributionIn this paper, we analyze how transparency requirements for short sales affect investors' behavior and security prices. We utilize the novel transparency regulation for short sales introduced in the European Union and observe both public short positions above, and confidential positions below, the disclosure threshold in Germany. Our main research questions are as follows. First, we investigate whether investors are reluctant to increase their short positions beyond the public disclosure threshold. Second, we analyze whether such reluctance represents a short-selling constraint on the investors and therefore affects the efficiency of stock prices. ResultsWe document that a sizable fraction of investors are reluctant to disclose their short positions publicly. Just below the disclosure threshold, positions accumulate, exhibit an abnormally low probability of increasing, and remain unchanged for an abnormally long time. This reluctance to cross the publication threshold represents a short-sale constraint for a large fraction of investors. Consistent with the overpricing hypothesis, when the short-sale constraint imposed by the disclosure threshold is potentially binding, stocks exhibit negative abnormal returns of 1.0-1.4% on a monthly basis. Different placebo tests verify that the short-sale constraint originates from the disclosure rule. Overall, these findings suggest that the investors' reluctant behavior in response to the short-sale transparency regulation imposes negative externalities on stock market efficiency. This paper analyzes how newly introduced transparency requirements for short positions affect investors' behavior and security prices. Employing a uniq...