Case studies · 2008
The 2008 US short-sale ban
A temporary ban on short-selling financial stocks after Lehman's collapse pushed apparent put-call parity violations that were really the priced cost of the ban.
What happened
A collapse that made the ban feel necessary
Lehman Brothers filed for Chapter 11 bankruptcy on 15 September 2008, still the largest US bankruptcy filing on record. The next day, the Federal Reserve Bank of New York extended an $85 billion credit line to AIG in exchange for a 79.9% government equity stake. Confidence in financial firms was collapsing, and US regulators worried that short sellers were piling on, pushing bank and insurer share prices down further and feeding a spiral in which a falling share price itself looked like evidence that the firm was in trouble.
The order
On 18 September 2008 the SEC issued an emergency order banning short selling in the shares of financial companies, covering 799 names identified on a best-efforts basis by industry code. Its own press release rounded this to "799 financial companies"; the course deck's rounder phrase, "about 800 financial stocks," is consistent with that figure. The order took effect before the market opened on 19 September, with a narrow exception for options market makers until 11:59pm that day, so that they could hedge ahead of the 20 September options expiration. The Dow rose about 369 points (roughly 3.3%) on 19 September, on the combined news of the ban and the Treasury's newly floated TARP bailout plan; the rally cannot be attributed to the ban alone, since the two announcements landed the same day. The SEC widened the list of covered firms on 21 September, and later extended the ban past its original 2 October expiry to 11:59pm EDT on 8 October 2008, when it finally lapsed after 19 calendar days in force.
The move into options
With the direct route to a bearish position closed, investors who wanted to bet against a bank or insurer moved to options instead, building a synthetic short position by buying puts and selling calls. Robert Battalio and Paul Schultz's 2011 Journal of Finance paper is the key study of what followed: bid-ask spreads on options over the banned stocks widened sharply, and the "synthetic" share price implied by the options market drifted visibly away from the actual traded share price, exactly where put-call parity says the two should line up. A separate strand of research, by Ekkehart Boehmer, Charles Jones and Xiaoyan Zhang, found that short-selling activity in large banned stocks fell by around 77% during the ban and that market quality worsened for most of the affected firms.
The regulator's own verdict
By the end of the year, SEC Chairman Christopher Cox told reporters that, in hindsight, the Commission would probably not repeat the ban, saying its costs appeared to outweigh its benefits.
| Date | Event |
|---|---|
| 15 Sep 2008 | Lehman Brothers files for Chapter 11 bankruptcy protection. |
| 16 Sep 2008 | The Federal Reserve Bank of New York extends an $85 billion credit line to AIG for a 79.9% government equity stake. |
| 18 Sep 2008 | The SEC issues Emergency Order Release No. 34-58592, banning short selling in around 800 (799 named) financial companies. |
| 19 Sep 2008 | The ban takes effect. A market-maker exception runs to 11:59pm to let the 20 September options expiration clear. The Dow rises about 369 points (about 3.3%) on the ban and TARP news together. |
| 21 Sep 2008 | The SEC widens the list of covered financial companies (Release No. 34-58611). |
| 3 Oct 2008 | The SEC confirms the ban is extended to expire 11:59pm EDT on 8 October 2008. |
| 8 Oct 2008 | The short-sale ban lapses at 11:59pm EDT, after 19 calendar days in force. |
| Dec 2008 | SEC Chairman Christopher Cox tells reporters the Commission would probably not repeat the ban, as its costs appeared to outweigh its benefits. |
The identity under strain was put-call parity itself, for European options, \(c + Ke^{-rT} = p + S\). This is a model-free, no-arbitrage relationship, and in normal times any visible gap between the two sides can be closed by a conversion or reversal trade, which typically requires shorting the underlying stock. That is exactly the leg the ban switched off: during the ban, shorting was illegal for the named financial names, so the arbitrage that would normally have closed the gap was simply unavailable. Options market makers would normally hedge a synthetic short sold to a client by shorting the stock; unable to do that, they priced the missing hedge into wider spreads and a persistent gap between the options-implied "synthetic" share price and the real one. The course's summary line for this episode is that when a law appears broken, the constraint should be priced first. The identity had not failed. Its usual enforcement mechanism had been switched off by regulation, and the visible gap was the market's price for that.
Data and facts
| Quantity | Value | Source |
|---|---|---|
| Financial companies covered by the ban | 799 (rounded to “about 800”) | SEC Release No. 34-58592; SEC Press Release No. 2008-211 |
| Ban in force | 19 Sep – 8 Oct 2008 (19 days) | SEC Release No. 34-58592; Press Release No. 2008-238 |
| Options spreads on banned stocks vs comparable names | ≈$1.20 wider (≈24%) | Battalio & Schultz (2011), J. Finance 66(6), via secondary summaries |
| Extra transaction costs paid by liquidity-demanding investors | ≈$505 million | Battalio & Schultz (2011), via secondary summaries |
| Fall in short-selling activity, large banned stocks | ≈77% | Boehmer, Jones & Zhang, summarised at Harvard Law School Forum |
| Dow Jones move, 19 Sep 2008 | +≈369 points (≈3.3%) | CNNMoney, 19 Sep 2008 (ban and TARP news combined) |
The $1.20/24% spread figure and the $505 million transaction-cost estimate are attributed to Battalio and Schultz (2011), reached here through consistent secondary summaries of their paper rather than the paywalled journal text itself, so they are attributed to that paper rather than re-derived independently on this page. The 77% short-selling decline comes from a separate paper, by Boehmer, Jones and Zhang, and studies the stock market rather than the options market that Battalio and Schultz examine; the two findings belong to distinct literatures and are not merged here.
The lesson
- A persistent arbitrage violation is not automatically free money. When one leg of the trade needed to close it is blocked, by law, by margin, or by an unavailable borrow, the gap is the market's price of that constraint.
- Put-call parity is a model-free identity, but traders only enforce it by actually doing the arbitrage trade. Remove the ability to short the stock, and the identity can drift for as long as the constraint lasts.
- A rule aimed at one market can distort a connected one. Here a ban on short-selling shares showed up as wider spreads and pricing gaps in the options market, because market makers priced in the loss of their usual hedge.
- Even the regulator who imposed the ban later judged its costs outweighed its benefits, a reminder that market-design interventions made under crisis pressure are themselves uncertain bets, not obviously safe defaults.
Where it appears in the course
Think about it
- The ban targeted the stock market, but its clearest effects showed up in the options market. Why might a regulator overlook that kind of spillover when writing an emergency rule under time pressure?
- Options market makers kept a narrow exception to hedge until the 20 September expiration. What would have happened to option prices on banned stocks if that exception had not existed at all?
- Christopher Cox later said the SEC would probably not repeat the ban. What evidence would you want to see, before or during a future crisis, to decide whether a similar short-sale ban is worth its cost?
Sources
- US Securities and Exchange Commission, Emergency Order Pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934 Taking Temporary Action to Respond to Market Developments, Release No. 34-58592, 18 September 2008. sec.gov
- US Securities and Exchange Commission, Press Release No. 2008-211, "SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets," 19 September 2008. sec.gov
- US Securities and Exchange Commission, Press Release No. 2008-238, Statement of the SEC Division of Trading and Markets, 3 October 2008, confirming the extension of the ban to 8 October 2008. sec.gov
- Robert Battalio and Paul Schultz, "Regulatory Uncertainty and Market Liquidity: The 2008 Short Sale Ban's Impact on Equity Option Markets," The Journal of Finance, vol. 66, no. 6 (2011), pp. 2013–2053. cover page and abstract
- Ekkehart Boehmer, Charles M. Jones and Xiaoyan Zhang, "Shackling Short Sellers: The 2008 Shorting Ban," summarised on the Harvard Law School Forum on Corporate Governance, 23 May 2013. corpgov.law.harvard.edu
- Amit R. Paley and David S. Hilzenrath, "SEC Chief Defends His Restraint," Washington Post, 24 December 2008. washingtonpost.com
- CNNMoney, "SEC bans short selling for financials," 19 September 2008. money.cnn.com
