Why Is Short Selling Illegal in Some Countries?

Short selling fell under heavy scrutiny during the global financial crisis of 2007 and 2008 when Australia, Canada and several European nations placed bans on short selling of financial stocks. Since that time, regulations have been lifted or amended in some countries, but generally speaking, the United States has more liberal laws on short selling than most of the world.

Short selling is an investing technique that seeks to profit from the decline in a security's value. In essence, short selling represents the opposite strategy of traditional capital gains investing. When an investor short sells a stock, that stock is actually lent to the investor by a broker. The investor sells the stock, and then promises to buy back, or cover, the same number of shares and return them to the broker. This strategy only pays off when the stock declines in value from the date of sale to the date of repayment.

For decades, certain politicians and prognosticators have alleged that short selling can actually help cause market declines and recessions. There are several reasons why a country might ban short selling. Some believe short selling en masse triggers a sale spiral, hurting stock prices and damaging the economy. Others use a ban on short sales as a pseudo-floor on stock prices.

The Upside of Shorting

In the U.S., short selling falls under the regulatory authority of the federal Securities and Exchange Commission (SEC). While temporary bans on short selling financial stocks on so-called "downticks" have been implemented in the U.S., a long-term quantitative analysis on such actions finally led to a repeal of anti-short-selling regulations in 2007.

Most economists and investors believe short selling is an important part of the price discovery process and helps highlight flaws in company fundamentals, which sends important signals into the market. For example, short selling can assist with more efficient price discovery, hedging other investments, increasing market liquidity and lessening the impact of bubbles. Nevertheless, short selling is often misunderstood and therefore considered a risk, not unlike options trading, futures markets or margin accounts.

It's important to differentiate between normal short selling and naked shorting, which is prohibited under SEC regulations implemented in 2007 and 2008 after the financial crisis. In naked shorting, a trader sells shorts he neither currently owns or has confirmed he even has the ability to own. These are considered "fail to deliver" shares, and the SEC requires that these securities are tracked and published on a regular basis.