Bitcoin’s (BTC) rapid 50% price drop in the wake of Coronavirus concerns aroused chatter around banning the ability for traders to assume short positions in cryptocurrency markets. Question is, would that be the right move?

Crypto market daily performance. Source: Coin360

Crypto market daily performance. Source: Coin360

Flash crash raises spectre of shorting bans

On March 12 Bitcoin dropped to prices not seen since April 2019, shedding half its value as fear gripped markets worldwide. The massive sell-off was instrumental in the carnage in which all cryptocurrencies except stablecoins suffered.

Long positions worth around $1 billion were squeezed on Black Thursday, raising serious concerns about the long-term viability of leveraged and derivative trading in crypto markets. After the crash, Huobi’s derivatives trading platform, Huobi DM, introduced a partial liquidation feature aimed at providing a circuit breaker to limit trading losses when the market corrects sharply.

Furthermore, a significant percentage of crypto trading volume occurs on BitMEX, OKEx, Binance Futures, and FTX, suggesting leveraged trading is having a disproportionate impact on spot prices.

Last October, analytics data that crypto futures trading represented about 50% of the volume of spot trading. According to analytics firm Skew, before the dramatic slump, BTC futures trading had rolling open aggregate interest volumes around $5 billion.

BTC Futures - Aggregate Open Interest. Source: Skew

BTC Futures - Aggregate Open Interest. Source: Skew

According to crypto data analytics provider, Datamish, around a third of open Bitcoin margin positions are short (up from around 10% at the end of February).

Bitcoin price, total long and short interest (30 days). Source: Datamish

Bitcoin price, total long and short interest (30 days). Source: Datamish

Furthermore, data shows that currently roughly a third of those short positions are hedged.

Hedged and unhedged Bitcoin short positions (30 days). Source: Datamish

Hedged and unhedged Bitcoin short positions (30 days). Source: Datamish

The extraordinary circumstances buffeting markets could be mitigated if short selling was banned, but is this the right approach and even if so, is it feasible?

Traditional markets get protection from short selling pressures

Markets in Belgium, Greece, France, Italy, and Spain have all implemented bans on the short selling of some stocks, and Dutch authorities are considering following suit. In the wake of the last global financial crisis, markets globally placed short-selling bans on financial stocks to, in the words of the SEC, “protect the integrity and quality of the securities market and strengthen investor confidence.”

The rationale behind halting short selling is to help shore up nervous markets in times of uncertainty and volatility. Studies have found, however, that banning investors from taking short positions actually harms markets.

Alessandro Beber and Marco Pogano’s seminal study of short selling restrictions after the 2008 global financial crisis published in The Journal of Finance found that:

“The short-selling bans imposed during the crisis are associated with a statistically and economically significant liquidity disruption, that is, with an increase in bid-ask spreads and in the Amihud illiquidity indicator, controlling for other variables.”

In other words, it worsens volatility in the short-term. In the long-term, without the downward price pressure short sellers impose on markets, there is an absence of technical dampeners on speculative long trading. The cumulative risk here is the creation of asset bubbles.

Princeton researchers Jose Scheinkman and Wei Xiong also reached a similar conclusion in their study titled Overconfidence and Speculative Bubbles. The researchers found that when shorting opportunities are constrained and valuation disagreements arise, optimism and overconfidence will combine to create price bubbles.

In other words, without short pressure, traders tend to believe they will always have the opportunity to sell assets at a higher price than they bought them.

Is banning shorting in crypto markets impractical?

The effectiveness of banning shorting on crypto exchanges also relies on how practical it would be. Given the structure of the crypto trading industry, where numerous exchanges of varying sizes exist in a handful of jurisdictional environments, coordinating a set of rules would be virtually impossible.

Any rules that weren’t enforceable industry-wide would create market distortions. If one exchange did not permit shorting but another did, traders would use the arbitrage opportunities that would arise by buying crypto where there was shorting pressure and selling it where there wasn’t.

So even if shorting were introduced, it would risk inviting outlier exchanges to offer shorting opportunities to traders, thereby distorting price signals in an already small and young market.

Shorting places healthy bearish pressure on crypto assets. Banning it may alleviate some short-term pain during periods of extreme volatility but it would almost certainly stem the ability for the industry to mature over the long-term.

The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should conduct your own research when making a decision.