Market Efficiency and Stability Under Short Sales Constraints: Evidence from a Natural Experiment with High-Frequency Resolution

We examine how short-sales policy regimes affect the efficiency of price adjustments and market stability. Using a ‘threshold error correction model’ (TECM), we find a more rapid convergence rate to new equilibria for upward adjustments than for downward adjustments. Moreover, relaxing the short sales constraints essentially improves price efficiency. Our findings refute the claim that tighter constraints can help stabilize the market since the tightening of the short-sales restriction leads to increases in both market volatility and downside risk. These results hold even when market conditions and liquidity are controlled. Even though prices may fall more sharply without short-sales bans, rather interestingly, the evidence from our counterfactual policy analysis suggests that tighter constraints help restore market confidence. As a result, policymakers may practically optimize to strike a balance between the benefits of restored market order and the cost of elevated market volatility.