It’s SHO Time! Short-Sale Price Tests and Market Quality

We examine the effects of the Securities and Exchange Commission (SEC)-mandated temporary suspension of short-sale price tests for a set of Pilot securities. While shortselling activity increases both for NYSEand Nasdaq-listed Pilot stocks, returns and volatility at the daily level are unaffected. NYSE-listed Pilot stocks experience more symmetric trading patterns and a slight increase in spreads and intraday volatility after the suspension while there is a smaller effect on market quality for Nasdaqlisted Pilot stocks. The results suggest that the effect of the price tests on market quality can largely be attributed to distortions in order flow created by the price tests themselves. REGULATION SHO (REG SHO) PROVIDES a new regulatory framework governing short-selling of securities in U.S. equity markets. The rules were passed on September 7, 2004 and became effective on January 3, 2005.1 Reg SHO is intended to establish uniform locate and delivery requirements, create uniform marking requirements for sales of all equity securities, and establish a procedure to temporarily suspend the “provisions of Rule 10a-1 under the Securities Exchange Act of 1934 and any short-sale price test of any exchange or national securities association for short sales of certain securities for certain time periods” in order to “evaluate the overall effectiveness and necessity of such restrictions.”2 In this paper, we study the effect on market quality of the Securities and Exchange Commission’s (SEC) mandated temporary suspension of short-sale price tests for a set of designated pilot securities (Rule 202T—Pilot Program).3 ∗Diether and Werner are at Fisher College of Business, The Ohio State University. Lee is at Rutgers Business School at Newark and New Brunswick and at Korea University Business School, Seoul. We thank the New York Stock Exchange for financial support and seminar participants at The Ohio State University, theWharton School, the NewYork Stock Exchange, and BrighamYoung University for comments. We are also grateful for feedback received at the SEC Roundtable on the Regulation SHO Pilot. We thank Paul Irvine for comments and Yingdi Wang for research support. All errors are our own. 1 Securities Exchange Act Release No. 50103 (July 28, 2004), 69 FR 48008 (August 6, 2004). 2 Division of market regulation: Responses to frequently asked questions concerning regulation SHO (January 4, 2004). 3 Securities Exchange Act Release No. 50104 (July 28, 2004), 69 FR 48032 (August 6, 2004).