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This paper was commissioned by Managed Funds Association and produced by Copenhagen Economics. 

Short selling is an investment strategy used in financial markets that allows investors to profit from falling prices. When establishing a short position, an investor borrows a security (for example, a share of a company) from another market participant and then immediately sells the security. If the price of the security declines, the investor can buy it back at a cheaper price and return the security to the market participant who originally lent it out, earning a profit corresponding broadly to the difference between the prices at which it was initially sold and then subsequently repurchased.

It is well documented in economic research that short selling is an important mechanism for effective price discovery and therefore it is also beneficial for market efficiency. Short selling allows investors who believe an asset is overvalued to act upon this information, even if those investors do not already own the asset. As such, short selling facilitates the incorporation of all relevant information in the financial market. Short selling has also been shown to increase liquidity, reduce transaction costs, and detect fraud.

Despite the fact that economic research finds clear market benefits of short selling, it is sometimes a frowned upon aspect of financial market activity, possibly because short sellers profit from downward price adjustments. Some regulatory jurisdictions, such as the European Union and the United Kingdom, have enacted special disclosure requirements for short positions that are more intrusive than the requirements for conventional long positions: investors in Europe are required to publicly disclose their position when they have a short position that equals or exceeds 0.5 percent of the issued share capital (in contrast, the threshold for a long position is usually 5 percent), and to privately disclose their position to regulators at 0.2 percent of the issued share capital.

The individual public disclosure requirement impacts the behaviour of
financial market participants

Individual public disclosure requirements can be expected to influence market functioning, as investors in general, need to take account of the signals their public disclosure would send to other market participants, company executives, and regulators. As such, the disclosure requirement might affect an investor’s decision to take a significant short position:

  • Without the public disclosure requirement, the decision is simply: “Do I believe that the price of a certain company’s stock is likely to decline.”
  • With a public disclosure requirement, an additional condition is added to the decision: “Do I want other investors or the shorted company’s management to know that I believe that the price of the company’s stock is likely to decline.”

These are fundamentally two different decisions, where the latter question creates a disincentive for investors to build short positions to the extent they otherwise would.

Empirical studies show that investors avoid the individual public disclosure threshold

Identifying the exact impact of the disclosure requirement on market efficiency is complex because market outcomes are the product of multiple inputs.

Nevertheless, there are reasons to believe that investors prefer not to disclose their short position in a way that is likely to distort their investment decisions: First, investors’ short positions provide insight into their views on the stock’s outlook, which they might be reluctant to “give away” to the market. Second, short sellers are vulnerable to the predatory trading strategy known as a “short squeeze”. This occurs when other investors go long in a stock forcing the short sellers to unwind
their trades by buying back the stock at a higher price than where they initially borrowed and sold it.

The avoidance of public disclosure has been well documented in studies by the European Securities and Markets Authority (ESMA) and the Bundesbank. Using non-public data on positions below the public disclosure threshold, they find evidence of clustering, where investors tend to stop increasing their short positions to avoid breaching the 0.5 percent public disclosure threshold. In addition, they tend to hold this position just below the threshold longer than other positions, which
have already been publicly disclosed or are not close to the disclosure threshold. ESMA and the Bundesbank find that this longer holding period below the threshold suggests a reluctance by individual investors to breach the public reporting threshold.

In preparing this report, we did not obtain as detailed data as covered by the previous ESMA and Bundesbank studies. However, we did obtain data on non-disclosed data for the Danish market, where we see indications that prior results hold, as there is more movement below the public disclosure threshold than above the threshold.

This impediment to shorting due to investor reluctance to cross the public disclosure threshold has consequences for market functioning. Given that shorting, in general, is beneficial for price discovery, a limitation on shorting is likely to impair price discovery and thus reduce market efficiency. This is supported by the study from Bundesbank, which finds that stock prices are, in general, more out of sync with fundamentals when the disclosure threshold is binding. This leads Bundesbank to
conclude that “the short-sale transparency regulation imposes negative externalities on stock market efficiency”.

The individual public disclosure requirement can lead to herding behaviour

Another aspect that could impair market functioning is the possibility that the disclosure requirement causes herding behaviour. Herding behaviour can be described as the process when some investors do not act on their own beliefs, but rather copycatting other market participants including those who are believed to be informed investors. In the case of shorting, herding can occur when investors short a given stock directly as a result of a disclosed short position by another investor. This type of behaviour has been found to exaggerate price adjustment and therefore reduce market efficiency while leading to higher market volatility.

Based on data covering the major European markets, from 2015-2021, we find that the public disclosure requirement indeed does seem to lead to herding behaviour. Concretely we find that if there has been a short interest public disclosure in a stock over the past four days, the probability of observing a new public disclosure for the given stock is around 12 percentage points higher than it otherwise would have been. In estimating this, we controlled for other factors that could influence correlated behaviour among market participants. The results remain statistically significant when controlling for market volatility, returns, and trading volume, as well as general market trends (specifically by including date and stock fixed effects).

We confirm these results using the Danish dataset, where we also observe total non-publicly disclosed short interest (above the 0.2 percent threshold). Obviously, investors cannot react to non public short positions. Thus, we would expect to see a larger effect from a disclosure made publicly than from one that only goes to regulators if herding after short-interest disclosures exists. This is indeed what we find; the impact of changes in publicly disclosed shorts on total disclosed short interest is more than double the impact from changes in non-publicly disclosed shorts. However, there is still some reaction from non-disclosed data in the estimation, indicating that we do not perfectly control for the negative news.

Finally, we have investigated whether we can identify a direct link between the disclosure of short positions and increased market volatility. Given the wide range of factors that impact financial market volatility, we do not expect public disclosures to be the main driver, but nonetheless believe that implications from the disclosure requirement such as herding might contribute to greater volatility.

We do in fact find a modest, but statistically significant increase in volatility from a disclosure filing when examining our European dataset, covering 2015-2020. Concretely, we find that a short interest disclosure for a given stock increases stock volatility by 1.5 percent.

Summing up, in line with academic papers, as well as research papers by major European economic institutions, we have empirically identified that public disclosure of short selling is likely to impair price discovery for two main reasons: 1) it deters informed investors from shorting assets, thereby withholding information from the price discovery process and 2) it leads to herding behaviour, which is associated with a risk of exaggerated price adjustments and therefore higher volatility.