Requiring Short Seller Disclosure Could Distort Markets

In 2021, the head-spinning rise in stock prices for firms such as GameStop and AMC Entertainment threw the investment world into a tizzy. Individual retail investors coordinated over online platforms such as Reddit to purchase stocks in those companies, driving their value up. Investment firms that had been shorting the stocks—betting that prices would sink—lost a lot of money.

The episode brought more attention to ongoing debates about regulation of short sellers, including a proposal to require short sellers to disclose their positions in stocks. New research by Frank Zhang, a professor of accounting at Yale SOM, suggests that the proposed regulation could have unintended negative consequences. In a study of similar regulations in the UK, his team found that mandatory disclosure for short sellers led to “herding” behavior. When one investor revealed their short position, other investors often followed and shorted the same stock.

This isn’t good for the market, Zhang says, because it means that investors are making decisions based on other investors’ actions rather than information about the firm’s performance. Such activity can, in turn, push stock prices lower than their true value.

“Herding behavior is not based on firm fundamentals,” he says.

Short sellers make money by identifying a company whose stock they predict will fall. Then they borrow shares in that firm from a broker, with a promise to return them later, and sell the shares. If their predictions prove correct and the value declines, the short seller buys the shares at the lower price, returns them to the broker, and keeps the profit. (With meme stocks, prices shot up instead, leaving short sellers scrambling and incurring large losses.)

Proponents of short sellers believe that they play a valuable role in the market by keeping stocks from becoming overvalued. If investors get skittish and stop taking short positions, this correction mechanism could weaken, Zhang says.

The spotlight on short sellers during the meme stock frenzy revived a policy debate about disclosure. Right now, investors in the U.S. don’t have to reveal their individual short positions in a stock. But regulators generally believe that the “more disclosure, the better,” Zhang says.

So what would happen if the U.S. introduced mandatory disclosure? To find out, Zhang examined the results of a similar regulation in the UK, in collaboration with John Heater at Duke University, Ye Liu at Fudan University, and Qin Tan at the City University of Hong Kong. The team gathered data on 2,646 stocks from November 2012 to December 2020 from the UK, where investors are required to disclose their position when they short more than 0.5% of a company’s outstanding shares.

First, the researchers looked for “clustering”—that is, cases where multiple short sellers disclosed positions in the same stock around the same time. They found that when one investor revealed this information, more disclosures by other investors tended to follow.

The pattern could be explained in one of two ways. Perhaps all the investors had learned the same negative information about the firm and independently decided to short the stock. Alternatively, maybe the first disclosure had prompted other investors to follow suit—not based on information about the firm but simply because someone else had done it.

To distinguish between these possibilities, the team analyzed corporate news announcements. They reasoned that if short sellers were making decisions based on information about the firm, more clusters of disclosures should appear during the month after quarterly earnings news emerged. Clusters also would likely occur during the month before announcements, when investors were gathering private information about the firm and trying to take a position before it became public.

But that’s not what the researchers observed. Instead, clustering of short position disclosures was just as likely during periods of no news as during the months before or after news announcements.

“The results are consistent with the herding story,” Zhang says.

The team also looked to see if there was a reversal of “short interest,” the percentage of a stock that is being shorted. If investors were making decisions based on shared information, they should eventually close their positions and return the shares to the brokerage; as a result, the short interest for a given company should decline over time. But if the herding hypothesis was correct, then one investor’s disclosure should drive short interest in that stock higher, slowing down the reversal trend.

To investigate, the researchers created matching sets of stocks. In the first set, all the stocks had a short disclosure. Each of them was matched with a second stock, which had a similar level of overall short interest. But for the second stock, no short positions had reached the threshold for disclosure during the six-month window around the first stock’s disclosure.

For stocks with no disclosures, 39% of the short interest was reversed over 30 days. But for matching stocks with disclosures, the figure over the same time window was only 13%—a finding that supports the herding explanation.

Herding behavior could drive stock prices away from their true value, Zhang says. And disclosures also could allow retail investors—like those who pushed meme stocks’ prices up—to target short sellers who have taken large positions.

If investment firms avoid short selling as a result, he says, stocks are more likely to become overvalued. “Mandatory short position disclosure is not a good solution,” Zhang says.

Ultimately, meme stocks won’t be good for retail investors either, he predicts. For many of these stocks, current prices are still hovering far above their previous values and don’t reflect the firms’ true prospects. Eventually, the stocks could crash.

“I think a lot of retail investors will lose a lot of money,” he says.