With markets plunging around the globe, and with volatility hitting all-time highs, there have been a number of calls to close exchanges. Though these calls are no doubt (mostly) well-meaning and aim to control the chaos unfolding in markets, in reality they will cause much more harm than good. Here’s why.
Why close an exchange?
Let’s first ask ourselves why a government would want to close an exchange in the first place. Ostensibly, this would be done in order to stop panic selling and the resultant collapse in stock prices. This itself sheds some light on why such a move would be a bad idea. The very action of shutting down markets is a signal from the authorities to investors that the situation is much, much worse than is currently anticipated.
Consider the fact that the U.S. stock market stayed open during the 2008 financial crisis. It was closed following the September 11th terrorist attacks on the World Trade Centre, but that was more of a logistical issue due to the presence of rubble in downtown Manhattan, as well as ongoing safety concerns. A shutdown today couldn’t be interpreted as anything other than a complete capitulation by the government, meaning that the selling would probably resume at a much higher rate when the market were eventually re-opened.
The other problem with closing exchanges as a response to the coronavirus crisis is that many people will need to tap their 401k and other accounts as a source of cash. Last week’s jobless claims came in at a record 3.28 million, and there is no sign that this number will go down any time soon. Closing the market would cut off millions of people from a crucial source of cash.
What about just banning short selling?
If closing markets is not a good idea, how about just banning short selling? During times of crisis, it seems unpatriotic to bet against the health of an economy, particularly when it’s institutions like hedge funds buying credit default swaps on companies in systemically important sectors.
A number of European countries have introduced bans on the practice, including Italy, France and Spain, although the UK and Germany - the two biggest markets in Europe - have not. However, in reality, active short sellers do not control enough capital to really move the markets. Calls to ban short selling are generally based on considerations other than strictly financial ones, and in such environments, it is easy to rally support for these measures.
But there is a problem with banning the practice that goes beyond the fact that it will spoil the fun for a few shortsellers. For most large financial institutions, the ability to short equities is crucial for their hedging strategies. No shorting equals no hedging. If they are not able to hedge their long exposure, they will simply close those positions, which will lead to more selling pressure on the market, which is of course what the bans are ostensibly there to prevent in the first place. Sometimes, it is best not to intervene.
Disclosure: The author owns no stocks mentioned.
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