Do constraints on short selling (either via regulation or cost to borrow) generate inefficient prices? In this line of research, I argue that focusing on a single market is too narrow (Blocher, Reed, and Van Wesep 2013, J. Financ. Econ.). Much like the mortgage market is a factor in house prices (lower interest rate mortgages support higher home prices), the securities lending market plays a role in stock prices. The securities lending market is a place where anyone who wants to sell a stock short must borrow the stock. The price to borrow a stock is set in the marketplace and, as such, is a function of supply and demand. As demand to short outstrips supply, spikes in the cost to borrow in the securities lending market inhibit short sellers.
In Short Trading and Short Investing, I show with coauthors Peter Haslag and Chi Zhang, that short selling should be thought of as two distinct activities which are often conflated in the literature. Short Trading, as we call it, is a short-horizon activity that helps with price efficiency, and has “normal” risk (i.e. the same as long investing in the same stocks) but only occurs when stocks are not short constrained. Short Investing is an activity that occurs among short constrained stocks and is higher risk, and longer horizon.
My paper Stock Options, Stock Loans, and the Law of One Price shows that regulations in one market (stock options) impact another market (the stock market). Specifically, we show how the removal of the options market maker exemption more tightly linked the options market and stock market, thus removing the options market as a possible channel for short selling. Instead, all short selling demand flows through to the stock loan market. This had the effect of increasing stock loan fees, thus increasing short-selling constraints, which had the expected effect of increasing mispricing and stock market inefficiency.
The paper Short Covering is the first study of covering trades on U.S. data. We use an accounting identity to measure the volume of covering trades bimonthly and show that short sellers are likely to cover their positions following price increases and loan fee increases, but that they also close their positions too early on average (i.e. prices continue to decline). This suggests that limits to arbitrage play an important role in short selling.
Continuing this theme, I also have a paper with Matt Ringgenberg called The Limits to (Short) Arbitrage, in which we show that short selling is actually pretty hard. Unconditionally, it isn’t, but conditional on actually wanting to short a stock, it can be quite hard to do so. This paper is currently under major revision as we attempt to measure short-selling constraints historically to expand our tests on well-known pricing anomalies. We believe that we will show that short selling constraints play an important role in explaining some persistent pricing anomalies.
My paper Supply side short-selling constraints: who is buying when shorts are selling focuses on the supply side in the securities lending market. Short sellers are sophisticated and usually have negative information about a stock. Why buy from them? We show that buyers lend those purchased shares at a rate significantly less than normal, generating a kind of endogenous short-selling constraint. Why? Because they are optimistic and do not want to enable short sellers. Those same stocks become more lottery-like, or exhibit positive skewness.
My paper Two-Sided Markets in Asset Management: Exchange-traded Funds and Securities Lending with Bob Whaley also investigates the supply side of the securities lending market. Here, we show that Exchange-traded Funds (ETFs) operate a two-sided market, much like credit cards. Credit card company have to navigate two markets: consumers (who they need to use the card) and retailers (who need to accept the card for payment). Both are charged a positive or negative fee (i.e. ‘cash back’ programs with credit cards). ETF’s two markets are investors and securities lenders. ETFs need to charge low enough fees to gather substantial assets, which they then turn and lend (at some fee) to stock borrowers. We implement a test by Rochet and Tirole (2006) to show that ETFs operate in a two-sided market and show that ETFs can sometimes make substantially more in securities lending than they make in management fees.
Overall, this strand of research focuses on the securities lending market more than short sellers. Another way of saying this is that I focus on the ‘supply side’ of the market (beneficial owners and stock lenders) rather than short sellers, who can be seen as the ‘demand side’ of the securities lending market.