DP17725 Short Sale Bans May Improve Market Quality During Crises: New Evidence from the 2020 Covid Crash
In theory, banning short selling stabilizes stock prices but undermines pricing efficiency and has ambiguous impacts on market liquidity. Empirical studies find mixed and conflicting results. This paper leverages cross-country policy variation during the 2020 Covid crisis to assess differential impacts of bans on stock liquidity, prices, and volatility. Results suggest that bans improved liquidity and stabilized prices for illiquid stocks but temporarily diminished liquidity for highly liquid stocks. The findings support theories in which short sale bans may improve liquidity by selectively filtering out informed—potentially predatory—traders. Thus, policies that target the most illiquid stocks may deliver better overall market quality than uniform short sale bans imposed on all stocks.