Short-Sale Constraints, Bid-Ask Spreads, and Information Acquisition

Abstract

Short-sale constraints are prevalent in many financial markets and have been actively adjusted by regulators to tackle problems in markets. However, how short-sale constraints affect market liquidity and information acquisition is still an open question. In this paper, we develop an equilibrium model to study this question in the presence of information asymmetry, inventory risk, and imperfect competition among market makers. In contrast to Diamond and Verrecchia (1987) and consistent with empirical findings, we show that the equilibrium bid (ask) price with short-sale constraints is lower (higher) than the bid (ask) price without short-sale constraints, which implies that short-sale constraints not only increase bid-ask spreads but also decrease both bid and ask depths. In addition, short-sale constraints increase liquidity risk measured by the volatility of bid-ask spreads. The presence of asymmetry information can further magnify the adverse impact of short-sale constraints on market liquidity. Furthermore, short-sale constraints make all non-market maker investors worse off while they may benefit market makers in equilibrium when there is significant competition. Interestingly, the presence of short-sale constraints may increase investors’ incentive to produce more precise information and thus improve aggregate information quality.