I have pondered over this question for some time now - 'Does short-selling make a market more efficient?' Or, to put it differently, 'Is short-selling a pre-requisite for efficient markets?' Here are my views on the same.
To answer the above question, we must first define 'market efficiency'. In my opinion, an efficient market is one where price discovery is solely based on the intersection of demand and supply functions. And any new information or event affects either or both of these functions, and hence results in the change in price. But as a whole, price is always arrived at by the demand function of the consumers and the supply function of producers.
In stock markets, the demand and supply functions are slightly complicated. The supply function is simpler to understand. During an IPO, its the standard supply function as in case of a manufacturing firm - higher the price, more the supply. As the valuations become richer, promoters supply more and more shares in the market. And as time passes, in a secondary market, the supply comes from prior period consumers (which were the demand function earlier). However, the supply side is still limited by the total amount of stock outstanding, and hence, has its upper-bound. It can always be estimated as coming from a single large firm with limited production - higher the price offered, more the supply.
Demand function, on the other hand, can come from anyone in the market place, and it has no upper-bound. However, it has a non-zero lower bound. So, there is always a positive demand, as well as a positive supply in a perfectly functioning markets. And it doesn't need 'short-selling' to function efficiently. In the worst scenario, there is no demand for the stocks, and hence, there is no trade in the market.
Now if short-selling is allowed, the supply function becomes as independent as the demand function. Everyone can become a supplier (that is, can sell the stock), and the upper bound on supply function disappears. Or, to look at it differently, now there is a possibility of a negative demand, and hence, must be matched by a positive demand. In falling markets where there is no positive demand, a negative demand if not met, can make a stock price nosedive towards zero. It will keep falling as long as it is matched by some positive demand. Hence, it can lead to quicker falls and higher volatility during the times of uncertainty.
Its a choice between a dry market with no trading (zero demand) or a highly volatile market with falling prices (negative unmet demand). And am not sure why the latter is better than the former.
To answer the above question, we must first define 'market efficiency'. In my opinion, an efficient market is one where price discovery is solely based on the intersection of demand and supply functions. And any new information or event affects either or both of these functions, and hence results in the change in price. But as a whole, price is always arrived at by the demand function of the consumers and the supply function of producers.
In stock markets, the demand and supply functions are slightly complicated. The supply function is simpler to understand. During an IPO, its the standard supply function as in case of a manufacturing firm - higher the price, more the supply. As the valuations become richer, promoters supply more and more shares in the market. And as time passes, in a secondary market, the supply comes from prior period consumers (which were the demand function earlier). However, the supply side is still limited by the total amount of stock outstanding, and hence, has its upper-bound. It can always be estimated as coming from a single large firm with limited production - higher the price offered, more the supply.
Demand function, on the other hand, can come from anyone in the market place, and it has no upper-bound. However, it has a non-zero lower bound. So, there is always a positive demand, as well as a positive supply in a perfectly functioning markets. And it doesn't need 'short-selling' to function efficiently. In the worst scenario, there is no demand for the stocks, and hence, there is no trade in the market.
Now if short-selling is allowed, the supply function becomes as independent as the demand function. Everyone can become a supplier (that is, can sell the stock), and the upper bound on supply function disappears. Or, to look at it differently, now there is a possibility of a negative demand, and hence, must be matched by a positive demand. In falling markets where there is no positive demand, a negative demand if not met, can make a stock price nosedive towards zero. It will keep falling as long as it is matched by some positive demand. Hence, it can lead to quicker falls and higher volatility during the times of uncertainty.
Its a choice between a dry market with no trading (zero demand) or a highly volatile market with falling prices (negative unmet demand). And am not sure why the latter is better than the former.
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