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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

Country Is shorts selling Allowed? Practiced?

Remarks Derivatives market

Argentina Yes No Strong limitations Active

Brazil Yes Yes Strong limitations Active

Chile Yes Yes Introduced, with restrictions, in Nov. 2001 Developing

China (Hong Kong)

Yes Yes Active

China (Shanghai)

No No Active

Colombia Yes No Rarely practiced

Czech Rep. Yes Yes Developing

Egypt No No

… … … … … Taiwan Yes Yes Developing

Thailand Yes Yes Low volume Developing

Tunisia No No

Turkey Yes Yes Short selling volume 4.5% of total trading volume in 2008.

Developing

Venezuela Yes No

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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.

SS countries Volatility Sharpe ratio Skewness Kurtosis Extreme

returns (%) M.A.D.(%)

Brazil 0.32 100 1.08 100 -0.37 100 4.04 100 3.83 100 20.95 100 0.54 172 -0.68 -63 0.13 -33 5.64 139 6.90 180 61.58 294 0.23 71 0.67 62 -0.19 50 4.81 119 5.36 140 12.35 59

Chile 0.22 100 -0.30 100 -0.19 100 5.04 100 4.98 100 29.94 100 0.31 140 -0.23 77 0.78 -417 14.22 282 4.98 100 32.23 108 0.15 66 1.83 -616 -0.08 44 4.50 89 4.60 92 9.22 31

… … … 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.

NSS countries Volatility Sharpe Ratio Skewness Kurtosis Extreme

Returns (%) M.A.D. (%)

Argentina 0.30 100 0.20 100 -0.24 100 4.23 100 5.36 100 29.45 100 0.62 204 -1.28 -644 -0.58 237 6.84 162 6.13 114 72.08 245 0.31 102 1.68 845 0.28 -113 6.02 142 4.21 79 17.22 58

China Shanghai

0.43 100 0.78 100 -0.17 100 4.77 100 6.13 100 44.12 100 0.55 128 -0.82 -104 0.26 -151 5.64 118 5.36 88 64.78 147 0.26 60 0.83 106 -0.03 19 3.11 65 3.83 63 14.40 33

… … …

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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.