Academic journal article Financial Management

Distribution of Ownership, Short Sale Constraints, and Market Efficiency: Evidence from Cross-Listed Stocks

Academic journal article Financial Management

Distribution of Ownership, Short Sale Constraints, and Market Efficiency: Evidence from Cross-Listed Stocks

Article excerpt

We investigate the interplay between the distribution of ownership, short sale constraints, and market efficiency. Using minute-by-minute data during the period surrounding the short sale ban of 2008, we demonstrate that short sale restrictions cause price disparities among cross-listed stocks when ownership in the stocks is distributed unevenly across the two markets. The stocks tend to trade at a premium in the market where long sellers are relatively scarcer, which reduces the speed at which prices adjust to bad news. The premium is driven primarily by an increase on the ask side of the market where ownership is thinner, is only evident when prices are moving down, and disappears quickly.

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The notion that short sale constraints act like "sand in the gears," preventing arbitrageurs from enforcing the "law of one price," is already well established empirically, but there is no consensus in the literature as to how a stock's ownership distribution across competing trading venues affects the way in which short sale constraints impact market efficiency. We address this important question in the context of US cross-listed stocks around the temporary short sale ban imposed by the Securities and Exchange Commission (SEC) on financial stocks from September 19, 2008, to October 8, 2008.1

US cross-listed stocks from Canada offer an especially convenient vantage point for this investigation for three key reasons. First, ownership in Canadian cross-listed stocks is heavily tilted toward Canadian domiciled investors. Figure 1 demonstrates that domestic investors capture more than 80% of all Canadian financial shares held by Canadian and US investors combined, suggesting that the short sale ban was more binding on the United States due to the relative scarcity of long sellers in the United States when compared to Canada. In addition, short interest

in Canadian financial stocks was up to five times larger in the United States before the ban, compounding the effect of the relative scarcity of long sellers on the US side. This is illustrated in Figure 2, where we scale short interest in each country by the number of shares held by local institutions. Moreover, the ban was imposed concurrently in Canada by the Ontario Securities Commission (OSC) on Canadian financial stocks cross-listed in the United States, ruling out regulatory arbitrage between the two trading venues during the ban. (2) Thus, the short sale ban of 2008 creates a controlled experimental setting where we can examine the interplay between the distribution of ownership, short sale constraints, and market efficiency.

Diamond and Verrecchia (1987) posit that short sale constraints do not typically affect price levels, but reduce the speed at which prices adjust to news, especially bad news. (3) From this perspective, absent ownership considerations, one would not expect the frequency or the severity of violations of the law of one price between the two trading venues to be affected during the ban. After all, when stocks are traded in two markets concurrently, market participants can easily "look over the fence," to see the prices at which the stocks are trading in the other market and adjust prices accordingly. However, if ownership is distributed unevenly across the trading venues, the short sale constraint will be more binding in the market with a relative shortage of long sellers or a relative over-reliance on short sellers (or both). Then it is eminently conceivable that violations of the law of one price will arise simply because the two markets won't be able to adjust to bad news at the same pace. In other words, we see the uneven distribution of ownership in a stock across trading venues as a legitimate and rational limit to arbitrage whose impact has not been investigated previously. We predict that violations of the law of one price between the United States and Canada during the ban will be neither larger nor smaller, on average, among Canadian financial stocks. …

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