JANET McFARLAND

Wednesday, February 04, 2009

Canada was not experiencing problems with abusive short selling before regulators shut down shorting of financial services company stocks last September – but the shutdown had “a significant impact on market quality” during the period of the ban, two new studies have concluded.

The Investment Industry Regulatory Organization of Canada on Wednesday released two reports examining trends in short-selling of stocks last year.

IIROC concluded shorting of Canadian bank stocks was in line with historic patterns last fall, and in fact was declining before the Ontario Securities Commission prohibited short-selling in 13 financial services stocks on Sept. 22.

But IIROC's review – commissioned by provincial securities commissions – concluded the prohibition on short selling for almost three weeks decreased both liquidity and increased the “spread” between the highest price bid and the lowest price offered to sell shares of the affected companies.

The OSC prohibited short selling in 13 financial services stocks last fall after the U.S. Securities and Exchange Commission banned shorting of almost 1,000 financial stocks in an effort to stop abusive trading.

The SEC was concerned the short selling was putting downward pressure on the value of financial companies.

The ban met with a criticism by market participants, especially in the United States, as investors argued it made markets more volatile and increased trading costs.

The IIROC reviews suggest Canadian markets were also hurt by the halt in short selling.

Short sellers borrow shares and then sell them in the belief that their prices will fall. They go back into the market later and replace the borrowed shares at lower cost and pocket the difference as profit.

According to an IIROC review, there was evidence of unusually high trading activity in financial company shares in the week before the short-selling ban was imposed. But there was not evidence of unusual levels of short selling of financial services company shares, including shares interlisted in the United States.

The review also found the ban on short selling reduced available liquidity in shares of the affected companies. The affected stocks accounted for a lower percentage of over-all market trading during the ban – in the volume of shares traded – than before or afterward.

The price spread between the highest price bid and the lowest price offered for the shares of the affected companies – known as the bid/ask spread – also tripled during the period the short-selling ban was in place, climbing from 0.13 per cent to 0.44 per cent during the period the short-selling ban was in place.

© The Globe and Mail