What China Can Learn From America’s Response to a Market Crisis

shanghai-stock-exchange.gi_.top_While trying to stem the severe recent market sell-off in local shares Chinese officials have tried increasingly drastic measures to prop up their markets, including investigating and threatening to arrest those involved in “malicious short selling.” They should heed the lessons of the short sale ban imposed by the U.S. during the 2008 financial crisis.

That ban, which was announced on the evening of September 18th and covered hundreds of mostly financial shares, was introduced as a panic response to the stock market sell-off triggered by the collapse of Lehman Brothers a few days prior. As news of the ban spread overnight it triggered a massive short squeeze – a volatile situation where short sellers scramble to buy shares to close out their position, driving the price of a stock violently higher and forcing other shorts to have to do the same.

By the morning of the 19th the buying was so frantic that prior to the open of the regular trading session futures on the S&P 500 (which trade overnight) where locked limit-up for the first time ever, a condition normally reserved for smaller and more volatile futures markets. Those of us lucky enough to be long futures into that open will always remember fondly how we scrambled to figure out when the limit would be lifted so we could unload our positions at a hefty profit. The shares of many major financial companies opened for trading with 20 or 30 percent gains.

To some observes it seemed like the SEC had succeeded in stemming the bleeding. But more seasoned investors were unnerved by the sudden rules change and its implication that market integrity might now be scarified in exchange for a short term rally. Ultimately the skeptics were proven right as within two trading days the stock market’s gains – among the biggest up opens and closes in market history – were completely reversed. The S&P 500 would not bottom out until months later at a value 40% below where it stood the day before the short selling ban.

In the ensuing months and years the architects of the ban would admit that it was a mistake and most likely hurt the markets more than it helped . Several months after the ban then SEC Chairman Christopher Cox admitted to a reporter from Reuters that “The costs appear to outweigh the benefits.” In 2012, in a comprehensive study of the short sale ban the Federal Reserve Bank of New York stated that the ban “seem to have the unwanted effects of raising trading costs, lowering market liquidity and preventing short-sellers from rooting out cases of fraud and earnings manipulation”

That report further concluded that not only did the ban not prevent stocks from falling, it also cost investors upwards of $1B in additional expense and lowered liquidity. Having participated in the action in real time, myself and other traders saw an even greater cost: the removal of an important buffer during serious declines. In a normal market sell-off major declines are constantly met by waves of buyers as shorts cover their positions to book a profit. During the dark days of late 2008 and early 2009 however no such buyers existed, as the SEC had summarily executed them on that fateful September morning.

Perhaps even worst, the SEC had sent a signal that the stock market is a rigged game where the rules are not fixed. That sort of signal scares away long term investors and hurts liquidity. Since the Chinese have taken far more drastic actions in recent weeks to prop up their stock market we can expect a more severe outcome. On top of demonizing short sellers they have also suspended the trading of countless stocks, cancelled all IPOs and banned insider selling.

To a laymen this “whatever it takes” attitude might seem appropriate, but a more seasoned investment professional is going to take pause. Liquidity and access to capital are just as important to a healthy market as price. When authorities show a willingness to throw all of that out of the window to stop a sell-off then many will take the lesson that when it comes to Chinese equities access to your money might disappear at any moment. A market that you might not be able to sell into tomorrow is a market you probably don’t want to buy today.



February 2018
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