Japanese ban naked shorts despite liquidity fears

The Japanese Financial Services Agency today banned naked shorting of stocks on the Tokyo exchange until the end of Q1 in 2009. But the experience of other countries implies the country now risks making the stock market even more volatile and illiquid.

In the wake of today's record-breaking 12.6% plunge, which took the Nikkei 225 index to a 26-year low of 7,162.90, the FSA announced it would compel investors with more than 0.25% short positions to report their positions to brokers, and would ban naked short selling altogether until March 31.

But such bans, introduced in several other countries including the US, the UK and Europe, have had several unintended consequences. In its Q3 results, Credit Suisse blamed its investment bank losses on the volatile September markets, which it said had been made even worse by the short selling bans. "The temporary restrictions on short selling of financial institution stocks exacerbated fluctuations in those stock prices as liquidity deteriorated, further disrupting the orderly functioning of equity markets and severely impacting the convertible bond market".

“The convertible bond market has been under unbelievable stress,” noted one global head of equity derivatives in London. “A large part of that market is financials-led, and the majority is held by hedge funds, typically in convertible arbitrage portfolios. That doesn’t work when shorting is restricted. So the convertibles market will have to find a new home, and that is going to be a big step.”

Statistical arbitrage funds have also pulled back from the market – a fact some claim contributed to reduced liquidity and higher volatility in the banned names. These funds have been major providers of liquidity in recent years, using algorithms to identify and profit from pricing anomalies in related securities. In practice, a stat arb fund may take long or short positions in hundreds or even thousands of stocks a day.

The withdrawal of these players had a noticeable effect on liquidity and bid/offer spreads, said dealers. According to research by Credit Suisse, restricted stocks accounted for around 28% of all US volumes in the week prior to September 19, when the SEC introduced its ban. This had fallen to around 20% of total volume by the following week. Bid/offer spreads also widened, from an average of around 17 basis points for much of 2008 to 40bp in the week following the ban and nearly 60bp by October 8, when the US ban expired.

On top of that, the pullback of hedge funds has led to heightened volatility, the Credit Suisse analysts wrote. As many hedge fund strategies are aimed at seeking out mis-pricings, stocks rarely move too far from fundamental value, reducing large price swings. The absence of these participants meant volatility on the restricted stocks stayed at elevated levels, they argued.

• An in-depth look at the impact of the short selling bans will appear in the November issue of Risk, published next week.

See also: Credit Suisse plunges into the red after investment banking losses