With the global financial system seemingly on the brink of collapse this past fall, regulators around the world temporarily banned the short-selling of certain financial services stocks in an effort to stem the crisis.

New research, however, shows that the controversial decision had an impact on market quality in Canada in the form of lower liquidity and wider spreads.

Canada’s contribution to the temporary ban on short-selling was basically aimed at thwarting any regulatory arbitrage with the U.S. The Canadian ban applied only to interlisted financial services stocks and came in response to measures that were introduced by the U.S. Securities and Exchange Commission in an effort to halt the huge downward pressure on financial services stocks that had developed.

At the time, the decision was controversial — not least among hedge fund managers, who use short-selling as an integral part of their portfolio strategies. More generally, it appeared that regulators had temporarily abandoned a belief in free markets and were intervening to prop up stocks artificially. Additionally, issuers that weren’t covered by the ban feared that frustrated short-sellers would use them as a proxy for the financial services companies they were prevented from trading, shorting the closest reasonable facsimile instead.

Mercifully, the ban was short-lived (Sept. 22 to Oct. 8), and there have been no efforts to revive it. Also, the global financial system is still standing — at least, for now. So, arguably, the ban did its job.

We’ll never truly know whether this effort saved the financial services sector, but new research from the Investment Industry Regulatory Organization of Canada confirms that the ban did have costs.

In early February, IIROC released a study, conducted at the request of the Canadian Securities Administrators, that found the ban “appeared to have a significant impact on market quality,” including an increase in trade spreads and a decrease in liquidity for the stocks that were covered by the ban.

The study also found that there was no real buildup of short-selling pressure in the protected stocks ahead of the ban’s imposition. Although the level of trading activity in financial services sector stocks in the days leading up to the ban was “unusual,” the study found that short positions in the stocks that were protected under the ban were in line with historical levels — and in line with other interlisted securities, generally. In fact, the short positions in the interlisted financials were declining at the time.

The IIROC study also found no meaningful difference in the price action during the ban between financial services sector stocks that were protected and those that were not. That should come as some comfort to those issuers who feared being targeted by frustrated short-sellers.

The question in hindsight, then, is whether the short-selling ban was worth it. Although the IIROC study concludes that the ban had a negative impact on market quality — and it suggests that there wasn’t any great short-selling pressure building up in the financial services sector in advance of the ban — the provincial securities commissions did face a regulatory arbitrage problem once the SEC adopted its ban.

(Other jurisdictions around the world did adopt restrictions of varying scope and duration; it wasn’t just a U.S. phenomenon.)

Phil Schmitt, chairman of AIMA Canada, the Canadian chapter of the London-based Alternative Investment Management Asso-ciation, and president of Toronto-based Summerwood Group Inc., suggests regulators cannot conclude that the ban had a positive effect, given that spreads widened and liquidity declined as a result. However, he notes, the apparent consensus at the time that the move was justified, given that regulators were concerned primarily with the stability of the financial system.

“The Canadian regulators, to their credit, did not extend the prohibition any further than was required to eliminate regulatory arbitrage,” Schmitt says. “It would have been imprudent to allow short-selling of interlisted securities here but not in the U.S. Again, to their credit, regulators did not impose any further restrictions.”

So, although Canadian regulators may not have seen the need for a short-selling ban in our markets, the decision may well have been warranted in light of the SEC’s action. Whether the CSA would make the same decision in the future if faced with similar action by the SEC remains to be seen.

@page_break@The Ontario Securities Com-mission stands by its decision to support the ban, calling it a “precautionary” measure. “It was the responsible thing to do to protect our markets from regulatory arbitrage,” says an OSC official, “and to support a regulator with whom we have similar interests.”

In the meantime, there’s the question of what will happen with short-selling regulation generally. In 2007, the SEC did away with its “uptick rule,” which some have blamed for exacerbating the financial crisis — the theory being that if the rule had been in place this past fall, it may have served as a brake on the selling pressure.

UPTICK TEST RULE

Before the crisis took hold, Canadian regulators also were toying with the idea of getting rid of their uptick test rule, and they did adopt a measure to suspend the uptick test for all interlisted stocks — again, to avoid regulatory arbitrage between Canada and the U.S.

Whether or not Canadian regulators go ahead and get rid of that rule will probably depend, in part, on what happens in the U.S. If the SEC restores its uptick test rule, it is unlikely the CSA will move in the opposite direction. However, if the SEC leaves its rules alone, it should be easier for Canadian regulators to follow suit — particularly as regulators have concluded that Canada doesn’t seem to have the problems with naked shorting and abusive short-selling that other countries have.

Along with the study into the effects of the temporary short-selling ban, IIROC also released another study that examines short-selling activity in Canada over a 17-month period ended Sept. 30, 2008.

Among other things, that study found there was no significant change in the pattern of short-selling during the period; that the exemption from the uptick rule for interlisted securities hasn’t had any discernible effect on short-selling activity; and that the number and proportion of failed trades has been declining.

It remains to be seen if this research will lead Canadian regulators to scrap the uptick test rule or not — although the IIROC study data appear to clear the way for such a move.

The OSC, however, is “not contemplating any changes to the short-selling requirements,” the OSC official says.

Schmitt speculates that there may not be the appetite to drop the rule in the current market environment. But, he suggests, “It could be a matter of time — calmer markets and calmer minds.” IE