Published Research

To Own or Not to Own: Stock Loans Around Dividend Payments

-Journal of Financial Economics (2021) - With Corbin Fox and Eric Kelley

A stock loan decouples ownership from equity exposure. This occurs because while securities lending agreements transfer the legal right to receive dividends – and any tax liability thereof – from the lender to the borrower, the borrower must reimburse the lender any dividend payments that occur during the life of the loan and return the shares upon recall. In a world where dividends and income from other sources are taxed differently, the separation of ownership and exposure matters as it gives investors an opportunity to earn dividend-like income from either dividends paid by the company or substitute dividends paid by a third party. Some investors who ordinarily lend shares may prefer not to do so around dividends if the tax levied on substitute payments exceeds that on dividends themselves, constricting the supply of lendable shares. This is currently the case for many in the U.S. Others seeking ways to avoid receiving dividends paid out by firms may choose to lend and receive a substitute dividend instead. These may include foreign investors—even those domiciled in tax havens—who face mandatory U.S. withholdings taxes of up to 30% on dividends. Demand for equity loans may increase as an arbitrageur with favorable tax status could borrow shares, receive a dividend, and split the tax savings with the foreign investor only to quickly return the shares to their original owner. This setting gives rise to a series of interesting questions. First, do equity lending markets experience meaningful supply and demand shocks when firms pay dividends? Second, do these changes result in lending constraints that are presumably unrelated to stock fundamentals? Third, since the availability of equity loans underpins the economically important role short sellers play in liquidity provision, do these constraints result in a deterioration of liquidity? We answer each question with a resounding “yes”.

We study the equity lending market around ordinary dividends paid by U.S. firms from 2009 through 2016. Our analysis emphasizes the dividend record date, which is the date ownership of the dividend is established. Consistent with meaningful lending market activities that ultimately constrain borrowers, we show that average equity lending fees, loan utilization rates, and the dispersion of fees across lenders all abruptly spike on dividend record dates and then quickly return to normal levels. This finding is consistent with both the supply and demand effects discussed above as standard economic theory predicts that both will be accompanied by an increase in price. Digging deeper, we explore each of these effects in detail. Although we find a significant reduction in shares available for lending, the quantity of shares on loan and the number of new loan transactions both increase, which indicates the demand effect dominates. The magnitudes are striking. While supply contracts by an average of 10%, the quantity of shares on loan on dividend record days surpasses its pre-dividend level by more than 20%, and the number of new lending transactions exceeds its average by well over 50%. Both quantity on loan and number of transactions return to their normal levels within two days. Moreover, the loans appear to be very short-term in nature, and the number of shares returned to lenders spikes exactly one day after the dividend record day. We bolster our conclusion regarding a dominant demand effect using Cohen, Diether, and Malloy’s (2007) supply and demand shift characterizations to show that dividends associated with outward shifts in demand outnumber those experiencing inward supply shifts by a count of more than four to one.

Business Cycle Variation in Short Selling Strategies: Picking During Expansions and Timing During Recessions

Journal of Financial and Quantitative Analysis (forthcoming)- With Eric Kelley

We present evidence that short sellers alternate between stock picking during expansions and market timing during recessions. First, firm-level short interest is a much stronger negative predictor of the cross-section of stock returns during expansions than it is during recessions. High short interest also only predicts negative future earnings announcement returns during expansions. We attribute these findings to short sellers’ emphasis on collecting firm-specific signals. Second, short sellers appear to make factor bets more so during recessions than they do in expansions. These bets tend to pay off as we observe a strong negative relation between the betas of highly shorted stocks and future stock market returns, a result which disappears during expansions. Together, these findings are consistent with theories of information acquisition under attention constraints, endogenous information production, as well as theories of time variation in aggregate overconfidence amongst traders.

These findings have important market efficiency implications. if short sellers collect and trade on fewer firm specific signals, then prices may be less informative with respect to firm specific information during recessions. This finding may help explain recent empirical evidence presented by Loh and Stulz (2018) and Schmalz and Zhuk (2018) which suggests that markets are more responsive to the release of public information during recessions. If less information is being traded into prices by sophisticated traders like short sellers during recessions, then the revelation of new public information contains a greater amount of un processed information. Additionally, short sellers play an important role as external monitors of the firm. If sophisticated traders such as short sellers collect fewer firm specific signals during recessions, then their role as monitors of the firm may diminish. Contrary to the predictions of Povel, Singh, and Winton (2007) this diminished monitoring may increase the likelihood of fraud during down economic times.

Why Do Short Selling Bans Decrease Price Efficiency and Increase Adverse Selection

- Review of Asset Pricing Studies (2021)

This study explores the link between short selling, adverse selection, and price efficiency. Adverse selection occurs when one party has more precise information about an asset’s value than the other. It is a key determinate of liquidity and affects many other aspects of finance. Prior empirical research links short selling and adverse selection by documenting that increased adverse selection appears to be a key driver of diminished liquidity during short selling bans. This finding is not intuitive. Short sellers are generally viewed as informed traders. Consequently, a short selling ban would be expected to decrease adverse selection by removing informed traders from the market. And, specifically, it should do so on the sell side of the market, where informed short sellers transact. The link between short selling and price efficiency is better understood. It has long been understood that restricting short selling harms price efficiency by preventing certain information from becoming incorporated into prices. What is not understood is the seemingly counterintuitive result that a ban both increases adverse selection—indicating that trades are more informative—at the same time it decreases price efficiency—indicating that prices are less informative.

I explore the link between a short selling ban, adverse selection, and price efficiency theoretically using a model with endogenous information acquisition. The model shows how a short selling ban can simultaneously increase adverse selection and decrease price efficiency. Additionally, and somewhat counter to initial expectations, the model predicts that a ban will increase adverse selection only on the sell side of the market.

The intuition for these results is straightforward. Adverse selection on one side of the market (say on sell orders) increases when the ratio of informed investors to liquidity traders in the pool of investors trading on that side increases. When short selling is allowed but costly, information acquisition concentrates among investors owning the asset. This occurs because the expected cost of transacting on information is less for them since they do not have to pay a short selling cost to trade on negative information. Consequently, the mass of informed investors in the market has relatively more investors who own the asset than who do not. Imposing a short selling ban prevents both informed and liquidity investors who do not own the asset from selling; this action lowers both the numerator and the denominator of the ratio of informed to liquidity traders on the sell side of the market. However, since the population of informed traders is skewed toward investors who own the asset, while the population of liquidity traders is not, the drop in the numerator of the ratio of informed to liquidity traders is smaller than the drop in the denominator, thereby increasing the overall ratio of informed to uninformed traders on the sell side of the market. Overall, price efficiency declines because the drop in the informativeness of buy market orders along with the convergence of some trades that would have arrived as sell orders in the absence of a ban to less informative no trade events more than offsets the increase in the informativeness of sell market orders.

Empirical analysis from the 2008 short selling ban in the United States (hereafter the ban or the short selling ban) provides results consistent with the predictions of the model. The ban decreases price efficiency. It also increases adverse selection, but only on the sell side of the market. This asymmetry is economically meaningful as I show that increased sell side adverse selection is the dominate factor contributing to increased transaction costs during the ban; that is, the ban disproportionately harms sell side liquidity leading transaction costs for sellers to increase 50% more than for buyers.

Working Papers

Tick Sizes and Market Quality: Revisiting the Tick Size Pilot

With Yashar Barardehi, Qiyu Liu, and Ariel Lohr

Large Trade Anticipation

With Kyoung-Hun Bae and Eun-Jung Lee

Research in Progress

State Dependent Preferences for Prospect Theory Stocks: Individual Investor and Asset Pricing Implications

With David Maslar and Brian Roseman

Do Recessions Increase the Incidence of Corporate Fraud

With Eric Kelley and Jerry Martin

Is There a Listing Exchange Premium

With Bidisha Chakrabarty, Amy Edwards, and Ilia Rainer