NEW YORK (Reuters) - The global crackdown on short selling has made volatile markets more erratic and may have exacerbated the recent plunge in financial stocks because of the disappearance of a key cushion: short covers.
With Monday’s record drops in North America rippling into Asia and, briefly, Europe on Tuesday, the undisputed culprits were U.S. lawmakers who defeated a $700 billion financial bailout plan.
Major indexes, including the Dow Jones industrial average and Nasdaq sank fast until, and even after, the close of markets, as traders scrambled under a crush of sell orders.
A sharply lower market can usually count on some support, especially toward the end of trading, from short sellers — who sell borrowed shares in the hope of buying them back later at a lower price — covering their positions.
But with nearly 1,000 U.S. financial firms covered under the Securities and Exchange Commission’s ban, much of that support is gone.
“We’re liquidity deprived right now and that absence means we can’t catch a falling knife,” said Jamie Selway, managing director at New York-based institutional broker White Cap Trading. “What shorts do is add liquidity (trading activity), which drives market quality and that’s defined by reduced volatility.”
UK regulators temporarily banned shorts on September 18. Other countries quickly followed suit in an effort to protect financial stocks said to be targeted by short sellers as the credit crisis worsens.
There is debate whether the move worked. It has split investors from Singapore to Canada, with some applauding the measures in such delicate times, while others bemoan the government intrusion in free markets.
Those who oppose the ban tended to agree it played some role in the sharp market drops.
But in general, the result of the ban has been a widespread decline in trading volume. It has also partly driven a spike in volatility — such as the record set on Monday on the Chicago Board Options Exchange Volatility Index .VIX, which measures Wall Street fear.
“That is the challenge around quickly implemented changes to what is the normal operating procedure — you can’t fully examine the consequences,” said Jim Dunigan, managing executive of investments at PNC Wealth Management. “If there are no shorts to cover that can exacerbate declines.”
On Monday, the Dow lost nearly 0.9 percent of its value in the last five minutes of trading. More selling was then carried out after the bell.
Bernie McSherry, senior vice president for strategic initiatives at Cuttone & Co, an institutional broker on the floor of the New York Stock Exchange, told Reuters: “There were some big imbalances to the sell side at the end of the day.”
The New York sell-off spread elsewhere in the Americas and later to Asia, where Japan’s Nikkei average hit a three-year closing low on Tuesday.
European stocks initially dropped, but then recovered as investors bet Washington would ultimately rescue the financial sector, now more than a year into the subprime mortgage- inspired downturn.
“Short selling helps prevent bubbles and, if there was a way to short real estate, maybe we wouldn’t be in this situation,” said Richard Gates, portfolio manager at mutual fund TFS Capital.
“The short sellers have a very important role in a healthy market. But looking at (Monday’s) markets, it’s hard to tell whether we would have lost more or less if the bans weren’t in place.”
The SEC is expected to extend its ban on short selling, which is set to expire October 2.
Additional reporting by Kristina Cooke; Editing by Andre Grenon