*3.3. Further Tests of Robustness—Causality*

The previous analysis shows that markets with short selling bans exhibit positive serial correlation and fat tail return distributions. However, that does not necessarily imply that it is the prohibition of short selling that causes market inefficiency. Islam and Khaled (2005) note that "emerging stock markets are in many cases characterised by a lower volume and frequency of trading ('thin trading'), ease of manipulation by a few large traders, weaker disclosure and accounting requirements, settlement delays, and a generally less than smooth transmission of financial information." Thus, any or all of these conditions, rather than a short selling ban, might lead to market inefficiencies and the return distributions for DSE stocks that we document.

To link a short selling ban with positive serial correlation and fat-tail return distributions, we look for a developed market that experienced a recent short-selling ban to see if the return distributions are structurally different before after the ban. In contrast to emerging markets, exchanges in developed countries tend to be more liquid, less prone to manipulation, and have greater informational transparency. If after the structural shift the returns distribution changes and looks similar to our DSE results, we can conclude that it is the short selling ban, and not other market impediments, that is at the root of our findings.

To perform our analysis, we turn to a natural experiment precipitated by the financial crisis. Worldwide, a number of countries banned short selling of stock on their national exchanges at the onset of the financial crisis. In some cases, regulators restricted the short selling ban to the stock of financial intuitions. Thus, we can examine run distributions before and after the ban and look for any differences. However, to do that, the short selling ban period must be long enough for the sample of runs to be indicative of the underlying population.

From Beber and Pagano (2013), we find that one of the longest short sale bans occurred in Australia, where prohibition of short selling financial institution stocks occurred from 22 September 2008 to 1 June 2009, a total of 170 trading days. The Australian Stock Exchange (ASX Group 2018) is the

15th largest, with market capitalization of \$1.442 trillion (World Federation of Exchanges 2017). In its corporate overview, the ASX states that it operates in a "world class regulatory environment", and its clearing houses are "among the most secure and well capitalised in the world." To further confine our analysis to the most liquid stocks, we examine the nine financial institutions in the ASX 200 index.

Table 6 illustrates the number of runs observed 170 days before and after the ban for each of the financial institution stocks in the ASX 200 index. In 7 of 9 cases, and in total, there are fewer runs after the ban. This result suggests that a short selling ban contributes to inefficiency and a positive serial correlation of returns.


**Table 6.** Number of Runs before (B) and After (A) Short Selling Ban in Australia.

Given the limited number of banned short selling days, we artificially constructed a longer time period by combining all nine stocks into one distribution. This simulates a return run distribution covering approximately six years. Figure 4A graphs the number of runs both before and after the ban. Similar to our earlier DSE results, there are fewer short runs (4 days or less) and more long runs (5 days or more) during the period in which short selling is banned. Figure 4B more clearly illustrates the long runs observed in the tails of the distribution. There are several more runs of positive returns that are 5 days or longer after the ban. Whereas the longest positive return run observed is 7 days before the ban, after the prohibition of short selling, we find one 10 day run. For negative return runs, the longest period observed is 8 days, whereas there are several examples of 9 and 10 day runs after the ban. In total, evidence from a natural experiment shows that prohibiting short sales contributes to relatively greater frequency of long runs, and reflects the market's need for additional time to digest new information.

(**A**) 

**Figure 4.** *Cont.*

**Figure 4.** (**A**) Runs Distribution for Australian Stock Returns Before and After Short Selling Ban; (**B**) Tails of the Runs Distribution for Australian Stock Returns (|n| ≥ 5 days).
