Short Selling in Emerging Markets: A Comparison of Market Performance During the Global Financial Crisis

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Short Selling in Emerging Markets A Comparison
of Market Performance During the Global Financial
Crisis
Dean Fantazzini and Marrio Maggi
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Reading Questions

• Why short selling is important for Emerging
  Markets?
• What are the effects of banning or restricting
  short selling?
• What are the requirements for implementing short
  selling?
• What are the main characteristics of short
  selling in Emerging Markets?
• What were the emerging markets performances
  during the last decade (2002 - 2010)?
• What were the emerging markets performances
  during the global financial crisis (2007-2010)?
• What were the main differences between emerging
  markets allowing for short selling and those not
  allowing it during the global financial crisis?

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The importance of Short Selling in Emerging
Markets

• The importance of short selling as a source for
  exogenous market liquidity was emphasized by
  several studies (see for example, Endo and Rhee,
  2006 Bris, Goetzmann and Zhu, 2007).
• Market illiquidity is usually considered as the
  consequence of low demand for securities, high
  transaction fees, limited supply of equity
  securities, inefficient market microstructures
  and a low confidence in the local market due to
  poor regulation and the lack of good corporate
  governance.

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The importance of Short Selling in Emerging
Markets

• Given these problems, an exogenous liquidity
  supply has been proposed as a way to quickly
  develop local equity markets.
• A possible source of exogenous liquidity is
  represented by foreign capital inflows which
  explain why many emerging markets have pursued
  this strategy during the last decade.
• An alternative form of exogenous liquidity is
  margin trading, intended both as short sales and
  as margin purchases, which has helped to
  accelerate the development of emerging equity
  markets as recently shown by Endo and Rhee (2006).

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The importance of Short Selling in Emerging
Markets

• The complete absence of regulated short selling
  or its restriction can seriously slowdown a
  market recovery.
• Moreover, the absence of short sales makes the
  market microstructure asymmetric favouring
  buyers, so that the market is much more
  vulnerable to speculative bubbles.
• A biased market may push prices to extremely high
  levels which can then result in a much more
  violent collapse.
• In addition, long positions cannot be easily
  hedged, and investors may either rapidly sell or
  hold their positions waiting for a market rebound.

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Short Selling Requirements

• Reliable market regulation is required for short
  selling to be effective.
• To make short selling viable, regulators must
  perform higher supervisory and regulatory roles,
  as well as additional tasks in maintaining and
  updating customer accounting data and other
  information.
• Furthermore, short selling and margin trading in
  general, require margin lending facilities able
  to perform daily rolling settlements as well as
  much more advanced money markets.
• A stock exchange regulator should avoid
  cumbersome and bureaucratic procedures which can
  make short selling impracticable.

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Selling in Emerging Markets Main Characteristics

• Countries are grouped into countries where short
  selling is allowed (SS countries) and countries
  where it is not allowed (NSS countries).
• Short selling is currently practiced in 13 out of
  31 markets, but we observe that it is allowed in
  22 countries.
• We also report whether a derivatives market is in
  place for two reasons first, derivative trading
  allows to speculate on falling prices even with
  short selling restrictions in place secondly,
  the existence of an option market is a signal of
  a more developed market infrastructure.

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Selling in Emerging Markets Main Characteristics
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Emerging Markets Indicators during the last
decade (2002 - 2010)
The thick and the thin lines represent, for each
date, the mean computed across SS and NSS
markets, respectively
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Emerging Market Performances during the Global
Financial Crisis (2007-2010)
For each SS country, indicators are grouped in
three rows before (top), during (middle) and
after (bottom) 2008. 05/07-05/08 05/08-05/09
05/09-05/10 For each indicator, values (left
columns) and relative values (right columns) are
reported. Indicators are computed on year long
windows. Relative values are computed setting to
100 the before value.
For each NSS country, indicators are grouped in
three rows before (top), during (middle) and
after (bottom) 2008. 05/07-05/08 05/08-05/09
05/09-05/10 For each indicator, values (left
columns) and relative values (right columns) are
reported. Indicators are computed on year long
windows. Relative values are computed setting to
100 the before value.
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Conclusion

• We reviewed the main characteristics of short
  selling in emerging markets, discussing how short
  selling restrictions can affect liquidity in
  emerging markets and considerably slow the market
  recovery after a financial shock
• Our empirical analysis showed that the mean
  volatility of SS countries is on average smaller
  than that of NSS countries, except for the 2008
  crisis.
• However, after 2008, volatility has quickly
  returned back to previous levels in SS countries,
  while this has not been the case for NSS
  countries.
• Interestingly, we also found that the average
  Sharpe ratios for NSS countries were generally
  better than those of SS countries before 2008,
  but after that year, the Sharpe ratios for SS
  countries have recovered much faster than those
  for NSS countries.

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Conclusion

• Returns skewness tends to be much more variable
  in NSS countries than in SS countries, while the
  average kurtosis for SS countries returns is
  lower than that of NSS countries.
• Finally, we noted that the frequencies of extreme
  returns and average annual maximum drawdowns are
  lower for SS countries than for NSS countries.
• This evidence makes us think of the famous
  anecdote of the "boiling frog (according to
  which "if a frog is placed in boiling water, it
  will jump out, but if it is placed in cold water
  that is slowly heated, it will not perceive the
  danger and will be cooked to death)
• Short selling allows the market to react quickly
  to any information, even at the cost of some
  "temporary scalds" (high temporary volatility).
  Restricting short selling practices condemns the
  market to a much slower recovery (lower Sharpe
  ratios, higher market drawdowns) and a lower
  liquidity, which can fatally limit its operation
  and slowly make it irrelevant for the local
  economy.