Replacing Short Selling in Stocks with ETFs: Effect on Stock Returns, Liquidity and Equity Lending Markets

Abstract

We examine if constrained equity short selling migrates to exchange-traded funds (ETFs). Using the 2008 short-sale ban on financial-sector stocks we show that ETFs can replace shorting individual stocks. Increasing ETF short selling leads to intensive creation of ETF shares to cater equity lending market. Migration from individual stocks to ETFs relaxes short selling constraints by mitigating the negative ban effect on stock liquidity. The robustness tests suggest that market pessimism does not drive these findings. Our analysis of short sales substitution adds to knowledge about interaction between ETFs’ and stocks.