Short selling contributes to turnover in the stock market both directly and indirectly in that it improves market efficiency, enhances market depth and reduces bid-ask spreads, according to a research paper published today by the Hong Kong Securities and Futures Commission (SFC).
A regression analysis that the SFC conducted for the period 2005 to 2008 shows that short selling encourages trading in the overall market in that it helps price discovery. It also helps narrow bid-ask spreads.
Some overseas markets tightened their short-selling regulations temporarily in response to the increase in market volatility after Lehman Brothers filed for bankruptcy last September. However, the report cites studies indicating that such restrictions did not necessarily reduce the volatility of stock prices. On the other hand, some of these measures might have reduced liquidity in the stock market, the studies say.
The full report may be found here: http://www.sfc.hk/sfc/doc/EN/research/research/RS%20Paper%2044.pdf