The impact of short-selling and margin-buying on liquidity: Evidence from the Chinese stock market

We propose a framework based on limit order book to analyze the impact of short-selling and margin-buying on liquidity. We show that when short-sellers are perceived as informed, adverse selection may lead to uninformed traders withdrawing their limit orders. Given that the Chinese stock market has strong information asymmetry and a high proportion of uninformed traders, we predict that the pilot program launched in March 2010, which lifts restrictions on short-selling and margin-buying for a designated list of stocks, may have a negative impact on liquidity. We perform difference-in-differences tests and show evidence that allowing for short-selling and margin-buying indeed has a significantly negative impact on liquidity for stocks on the designated list. In particular, the negative impact on liquidity is more pronounced for stocks with high information asymmetry. Nevertheless, when short-selling volume dries up due to regulation changes in August 2015, i.e., the “T+1” trading rule on short-selling, we show that consistent with model predictions, lifting restrictions on short-selling and margin-buying has a positive effect on liquidity.