In recent times many things have been said about the effect of short selling in stock returns. The most widely extended point of view blame short sellers of causing fatal market crashes, and being responsible of price manipulation, however this is not a recent point of view.
The first short selling restriction we are aware of happened in Holland in 1680, when short sellers were blamed of being the ones causing the fall in tulips market. This is a very extended point of view among market participants and regulators.
The fall of Bearn & Stearns in March 2008 caused a financial tsunami whose consequences remain, as a result the main response of regulators has been to limit short selling activity in the market. Regarding the Spanish market 22nd of September 2008 was the date the CNMV issued a regulatory note reminding all the agents the prohibition of naked short selling operations in the market for stocks and the obligation by short sellers of publishing their positions when these are above 0.25% of company's free float. However nothing has been said about the effect of this note on market performance. This study has a double objective, first to characterize the market for lending stocks, as the one relevant to understand the relation between short selling and market performance of a company, and also to disguise the relations between this market and the market of stocks.
The findings in this paper post evidence on the relevance of short sellers as liquidity providers. Short selling activity appears to have a non monotonic relation with company returns. When a stock performs better than the market short selling activity has no relation at all with this performance however bad performance and lending activity are negatively related. This result will be interpreted in terms of limited rationality and overreaction of stock markets.
Our results also suggest a negative relation between lending activity and the performance of future return in stocks, adjacent to this finding is the result on the effect of restrictions on lending activity and future stock returns. Opposite to the results in other papers we find no evidence on the effect of restrictions posted on the demand side of lending market but in the supply side. This could be interpreted in terms of the existence of monopolistic behaviors by lending suppliers or through the so called liquidity role of short selling activity.
We also analyze for the existing relation between market bubbles and lending. Regarding this topic, our results suggest a negative relation between short term market bubbles and constraints to lending activity, which is related to liquidity factors, however long term market performance appears to be unrelated to the existence of lending constraints. In sight of this result we can conclude that in the long term negative information is impounded in market prices, therefore lending constraints are more related to the speed in which this information is reflected in market prices than to the existence market bubbles.
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