Dividend Stocks

Why a Short Selling Ban Is Bad for Investors

For weeks, the prospect of a potential ban on short selling stocks has loomed over financial markets. In May 2023, as the banking crisis engulfed financial markets, institutional investors took the opportunity to bet against struggling bank stocks. This compelled JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon to call for regulatory action against the practice.

Since then, others have echoed the cry for a short selling ban, arguing that investors shouldn’t be able to profit off the misfortune of others. In addition, critics have called for further action against naked shorting. This refers to the illegal practice of selling shares short when their existence has not been confirmed. However, as the Wall Street Journal reports, the theory that naked shorting is common in U.S. markets is widely disputed by industry professionals.

There is no guarantee of a ban on short selling stocks. That said, it is important to understand how such a policy would impact investors.

The Case Against a Short Selling Ban

Short selling has long been a controversial practice. In March 2021, retail investors attempted to fight against it by staging the iconic GameStop (NYSE:GME) short squeeze. Two years later, the video game retailer has remained a popular target for short sellers. As InvestorPlace contributor David Moadel reports, this means it would stand to benefit from a short selling ban. Unfortunately, the unstable meme stocks that frequently attract short interest might be the only beneficiaries of such a policy change.

In response to the short selling ban speculation, one former financial market regulator made the opposite case. Jim Overdahl is the former chief economist of the U.S. Securities and Exchange Commission (SEC). In the Financial Times, he laid out exactly why a ban on shorting stocks is not a solution. As he notes, the SEC enacted a similar ban on short selling in 2008, which did not yield positive results, lasting only three weeks as a result. In his words:

“[Studies] found the ban was counterproductive, as it led to a severe degradation in market quality by increasing intraday stock price volatility, reducing market liquidity, increasing bid-ask spreads and price impacts, reducing pricing efficiency and increasing trading costs. It led to a substitution of other instruments to gain short exposure, such as equity swaps or credit default swaps. The studies documented impaired arbitrage and hedging processes caused by the ban leading some traders to unwind their positions, resulting in additional selling pressure on financial shares.”

Simply put, the short selling ban took already present problems in the market and made them worse.

Overdahl also notes that the failed ban proved the premise behind it incorrect: “that short sales were more aggressive than the sales made by those holding shares and wishing to dispose of them.” Fifteen years later, not enough has changed to make a new ban make sense.

There’s also the argument that a short selling ban doesn’t make sense because short sellers don’t target healthy companies. Activist short-selling firms such as Hindenburg Research have provided compelling cases against betting on unstable companies such as Mullen Automotive (NASDAQ:MULN) and Digital World Acquisition Corp (NASDAQ:DWAC). Sometimes shorting a company just makes financial sense, and other times it is the right thing to do.

On the date of publication, Samuel O’Brient did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.comPublishing Guidelines.

Samuel O’Brient has been covering financial markets and analyzing economic policy for three-plus years. His areas of expertise involve electric vehicle (EV) stocks, green energy and NFTs. O’Brient loves helping everyone understand the complexities of economics. He is ranked in the top 15% of stock pickers on TipRanks.