By Pedro Saffi, Professor at IESE Short selling is the practice of selling a financial instrument that the seller does not own at the time of the sale, with the intention of later purchasing the financial instrument at a lower price. Under normal market conditions, short selling is meant to increase price efficiency as well as add liquidity to markets. However, many people believe this practice to be among the many causes of several stock market crashes in the last 100 years, including that of 1929 and the current crisis that broke out in 2008. In fact, many of the short-selling regulations existing today originated from the Securities Exchange Act of 1934.

More recently, regulators around the world— including the SEC in the United States, the FSA in the United Kingdom and the CNMV in Spain—have imposed restrictions on short selling, considering it to have contributed to the major price drops occurring recently.

However, short selling does not affect the frequency of stock price drops. Moreover, it is incorrect to assume that, by removing constraints, investors are preparing themselves for a market crash. On the contrary, short-sale constraints hinder price efficiency and information revelation, which means price drops are greater in magnitude only when the news is widely known in the market. Hence constraining this practice could be damaging to stock markets as it would discourage trading for many investors who might have useful information that would affect prices.