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  • Strategic Trading as a Response to Short Sellers

    Marco Di Maggio, Francesco Franzoni, Massimo Massa, and Roberto Tubaldi

    This version: June 2020

    Abstract

    We study empirically whether short selling deters the incorporation of positive information. We find a sizeable

    reduction of positive information impounding before earnings announcements for stocks more exposed to short

    selling. The price pressure from short selling cannot explain this effect. Rather, consistent with strategic behavior,

    investors with positive views slow down their trades when short sellers are also present. Furthermore, they break

    up their buy trades across multiple brokers, suggesting they wish to prevent their information from leaking. The

    findings suggest that short selling can hinder price discovery when investors receive different information signals.

    Keywords: Short selling, Informed trading, Strategic traders, Institutional Investors, Market efficiency.

    JEL Codes: G12, G14, G23

     Marco Di Maggio is at Harvard Business School and NBER. Email: mdimaggio@hbs.edu. Francesco Franzoni is at USI

    Lugano, the Swiss Finance Institute (SFI), and CEPR. Email: francesco.franzoni@usi.ch. Massimo Massa is at INSEAD and

    CEPR. Email: massimo.massa@insead.edu. Roberto Tubaldi is at USI Lugano and the Swiss Finance Institute (SFI). Email:

    roberto.tubaldi@usi.ch. The authors are grateful for insightful comments to Francesco D’Acunto, Pierre Collin-Dufresne,

    Vyacheslav (Slava) Fos, Nicolae Gârleanu, Mariassunta Giannetti, Marcin Kacperczyk, Péter Kondor, Albert “Pete” Kyle,

    Sebastien Michenaud, Matt Ringgenberg, Clemens Sialm, Ken Singleton, Vish Viswanathan, Michael Wolf, and

    seminar/conference participants at: AFA, SFI Research Days, Nova Lisbon, ESSEC, CSEF-IGIER Symposium.

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    Introduction

    There is a widespread view in finance that short selling is beneficial for the market because it

    lets negative information seep into prices (e.g. Miller 1977; Diamond and Verrecchia 1987; Hong and

    Stein 2003; Ofek and Richardson 2003; Hong, Scheinkman, and Xiong 2006), improving price

    efficiency (Saffi and Sigurdsson 2011; Beber and Pagano 2013; Boehmer and Wu 2013; Porras Prado,

    Saffi, Sturgess 2016; Blocher and Ringgenberg 2019). However, regulators have not consistently

    embraced this view, as they fear the distortive effect of short sales for security prices. Over the years,

    they have imposed several restrictions on short selling, including the uptick rule in the U.S. and outright

    short-sale bans around the world, such as during the Great Financial Crisis.1 The work by Goldstein and

    Guembel (2008) provides theoretical support for regulators’ concerns. These authors argue that the

    opportunity to short sell a security opens the door for investors’ strategic price manipulation, which

    ultimately harms price informativeness. Given the recent resurgence of limitations to short sales in

    connection to the Covid-19 market rout, it seems urgent to revisit the question of the effect of short

    selling on financial markets (Enriques and Pagano 2020).

    This paper brings new evidence to this debate by studying a novel channel through which short

    selling may harm price discovery. We conjecture that the anticipation of a price decline induced by

    short sales leads positively-informed investors to strategically react with more cautious trading

    1 Rule 10a-1 from the Securities Exchange Act of 1934 established that short sales should be subject to price tests. This rule

    was implmented as NYSE’s Uptick rule and NASDAQ’s bid price test. In particular, NYSE Rule 440B provided that a short

    sale was only allowed on a plus tick. It was allowed also on a zero tick only if the most recent price change preceding the trade

    was a plus tick (called a zero-plus tick). According to NASDAQ Rule 3350, short sales were not allowed at or below the

    (inside) bid when the current inside bid was at or below the previous inside bid. The SEC lifted these restrictions in 2007, only

    to reintroduce them in 2010 in the form of ‘Modified uptick rule’ (Rule 201), which is triggered if the price falls at least 10%

    in one day. At that point short selling is allowed only if the price is above the current best bid. This aims to preserve investor

    confidence and promote market stability during periods of stress and volatility.

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    behavior. The latter can reduce price informativeness, potentially offsetting the beneficial impact of

    short sales.

    Our intuition relies on the theories that model the interaction of differentially-informed traders.

    In particular, Foster and Viswanathan (1996) argue that, when different traders receive different signals,

    information impounding in asset prices is delayed by the strategic behavior of investors with diverging

    beliefs. This happens because each group of investors has an incentive to defer trading in the expectation

    that the other group will push prices away from fundamentals.

    We conjecture that this theory describes the strategic response of informed market participants

    to the presence of short sellers. Specifically, investors with positive information will rationally decide

    to postpone and conceal their trades, waiting for short sellers to induce a price decline so that they will

    be able to acquire the asset at a lower price later on.2 This strategic behavior makes prices less likely to

    reflect positive views when short sellers are active in the market.

    Inspired by this theoretical prediction, we study how the presence of short sellers affects

    information impounding in stock prices at times when private signals are more likely to diverge. As a

    convenient laboratory, we focus on the period before earnings announcements, i.e. a time in which

    investors potentially disagree on the fundamentals of the asset. We find that, in the case of positive

    news, the amount of information that prices reflect is significantly lower when short selling is more

    aggressive. We show that the magnitude of the effect cannot be accounted for by the mere price pressure

    of short sellers. Moreover, to corroborate the hypothesis that this is the result of strategic behavior, we

    show that institutional investors slow down significantly their buy trades and break their orders across

    multiple brokers when short-selling activity is more pronounced. This evidence is consistent with the

    2 Several studies show that short selling predicts negative stock returns, including: Boehmer, Jones, and Zhang (2008),

    Boehmer, Huszar, and Jordan (2010), Engelberg, Reed and Ringgenberg (2012), Cohen, Diether, and Malloy (2007), Diether,

    Lee, and Werner (2009b), Rapach, Ringgenberg, and Zhou (2016).

  • 3

    intention of positively-informed investors to prevent the revelation of information to other market

    participants in the expectation of profiting from further price declines.

    Our working hypothesis relies on two assumptions. The first one is that short sellers and

    investors with positive information coexist in the market for the same asset. This is the standard

    assumption in models with investors that observe different information signals (e.g. Foster and

    Viswanathan, 1996, Hong and Stein, 2003). Indeed, in modern financial markets, investors appear to

    draw information from multiple unrelated sources. For example, while some traders rely on

    fundamental information, others react to quantitative signals. Some traders track high-frequency

    information and some focus on infrequent events (Crouzet, Dew-Becker, and Nathanson, 2019). Short

    sellers may also coexist with positively-informed investors as they short assets in the process of

    hedging. However, even if short selling activity results from hedging needs or from market making

    (see, e.g., Blocher and Ringgenberg, 2018), it will have a negative price impact (Ringgenberg, 2014).

    This implies that short selling can still induce strategic traders with positive information to wait out the

    price decline before engaging in their buy trades.

    The second assumption is that the presence of short selling activity is known to other market

    participants. Indeed, several channels contribute to spreading information about the extent of short-

    selling activity. For example, data providers publish daily statistics on the shorting market. Markit

    Securities Finance, which we use in part of our analysis, is one such example. Also, brokers that

    intermediate share loans can spread the word to their other clients to establish a reputation as valuable

    sources of information.

    To infer the trading behavior of informed investors, we use data on institutional transactions

    from Abel Noser Solutions (aka ANcerno). Prior work legitimates us to consider the institutions in

    ANcerno as informed investors (Chemmanur, He, and Hu, 2009; Puckett and Yan, 2011; Chemmanur,

    Hu, and Huang, 2010; Anand, Irvine, Puckett, and Venkataraman 2012; Anand, Irvine, Puckett, and

  • 4

    Venkataraman, 2013; Jame, 2017). Additionally, we select the more active traders in ANcerno to

    identify the subset of institutions that are more likely to place informed bets.