Short-selling and the
problem of market
maturity in Latin America
Miguel Díaz-Martínez and Emmanuel Fragnière
1
Reading Questions
1.
2.
3.
4.
Is portfolio theory and optimization techniques equally relevant when
evaluating the integration of short positions in asset allocation strategies in
Latin American stock markets as they are in developed economies?
If not, is it possible to adjust such techniques by adding variables related to
specific-country imperfections to make them applicable in Latin America?
What are the main issues that we should consider when considering short
sales in Latin America?
What conclusions can be drawn from a comparative analysis of short sales
in Latin American countries?
2
Context
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Latin American countries have particular structural features
that complicate the regulatory environment of capital
markets and affect the effective execution of short sales.
Specifically, Latin American capital markets are
characterized by:
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Reduced liquidity
Limited price formation
Unavailability of information
Small economic size
Factors affecting country risk perception from the
international investor perspective
All this makes it difficult to assess the appropriateness of
short sales norms
3
Review of national regulatory
regimes
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Brazil: Naked short selling is not allowed. Punitive rules that inhibit the non-delivery of
stocks at settlement (T+3). Some authors argue that The rules in place have limited
leveraged speculation therefore avoiding the expansion of the crisis.
Peru: Short selling can only be made with the shares listed at the Tabla de Valores
Referenciales 1 and 2, two lists that include the most liquid securities traded on the
Lima Stock Exchange. There are also price restrictions through the uptick rule.
Mexico: Short selling is allowed but there is an uptick rule. The Secondary Legislation
(Circular Única) establishes that short selling is only allowed through a Stock
Exchange, and for only highly liquid and semi-liquid stocks.
Chile: The government has issued a manual that contemplates the mechanics,
conditions and restrictions of short selling operations; and stock brokers have
developed standard formats to engage customers in short sales. However, short
selling in the stock market is not very developed and it is limited to a small number of
stocks. Naked short selling is not allowed.
Argentina: With some specific restrictions subject to the companies or securities
traded, non-naked short selling is allowed
Previous studies about short selling
in Latin America
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Literature is very limited and essentially derived from from
analysis conducted for the entire set of emerging countries
Bris et al. (2007): Studied 46 countries, and found evidence
that prices incorporate negative information faster in
countries where short sales are allowed and practiced.
Charownrook and Daouk (2009): Created a short-selling
feasibility indicator to analyze stock market indices around
the world. Their findings suggest that aggregate returns and
liquidity are better when short-selling is possible
Previous studies about short selling
in Latin America
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There is also a range of studies evaluating specific aspects in
individual countries and governmental studies assessing shortselling policies. Among these:

Torres et al. (2004): sustain that portfolio building methods are
based on hypothesis that are not real in emerging markets
 Agudelo et al. (2010): have undertaken a comparative analysis of
the Chilean and North American markets and concluded that,
where legal frameworks do not allow them, short sales can be
implemented through a temporary stock transfer contract
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Likewise, there is a range of government publications and
newspaper articles, but these are not theoretically conclusive
Previous studies on short selling in
Latin America
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Due to the inconclusiveness of short selling articles and the
lack of research, it is worth analyzing more general studies of
financial markets and economic assessments from
academicians and monetary authorities, such as:
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Feldstein (1999): examined the actions of speculators and the
macroeconomic events during the 1997-98 global financial crisis
 The Bank of International Settlements (BIS, 2002) published a
series of papers about the development of bond markets
 Regarding equity
markets there are various studies that
give an insight of stock market capitalization and emerging
countries efficiency (e.g. Bekaert and Harvey (2000))
Short selling in Latin America
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As explained earlier, Latin American markets are structurally
different making short selling more limited
To look beyond such limitations, we analyzed the relationship
between global capital flows and a wide range of financial
instruments traded in emerging countries
Our findings suggest that market liquidity and economic size
are the fundamental aspects allowing the development of short
sales
This allowed us to identify the characteristics of short sales at
three levels:
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Currency markets – these are normally big and very liquid
Debt markets – these are relatively big and liquid
Equity markets – these are normally not as liquid as currency
and debt markets
Short selling in Latin American
Currency Markets
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The possibility of short sell depends on the existence of a fixed
or a floating exchange rate regime
If the currency floats freely, investors can borrow local
currency, sell it for foreign currency, and then invest the
foreign currency; they then expect to sell their foreign
currency after the local currency's fall and repay the original
debt with cheaper currency
The elements usually considered by investors to evaluate short
sales against an emerging country’s currency are:
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The country’s current account deficit
Aggregated balance sheet imbalances in the banking sector
Banking implosions, and their consequent ‘contagion’ turbulence
These elements provide an indication of the expected
devaluation.
Short selling in Latin American
Debt Markets
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The possibility of short sell depends on the existence of
secondary markets, and repo and funding markets
If a speculator wants to short sell, he may sell a bond in
secondary markets, receive the money from the sale, and then
lend this money and receive a bond as payment guarantee. The
bond received as guarantee is transferred to the buyer.
At the maturity date of the lending the speculator will receive
back the money lent and use it to buy another bond with
exactly the same characteristics of the one he sold. This bond
is given to the money borrower (i.e. the original bond holder)
In Latin America and Eastern Europe, debt markets are
relatively liquid and deep in Brazil, Chile, Czech Republic,
Poland, Mexico, Colombia, Peru and Hungary
Short selling in Latin American Equity Markets
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Country
Argentina
Bolivia
Brazil
Chile
Colombia
Costa Rica
Ecuador
El Salvador
Guatemala
Honduras
Mexico
Nicaragua
Panama
Paraguay
Peru
Uruguay
Venezuela
Legality
Feasibility
1999
No
1986
1999
No
No
No
No
No
No
Yes
No
No
No
2002
No
No
No
No
No
2001
No
No
No
No
No
No
Yes
No
No
No
No
No
No
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Even though countries have developed
regulations on the topic, this table shows that
short selling in equity markets is not feasible
in the great majority of countries analyzed
In the analysis of debt and currency markets,
we found that short selling is very feasible,
and investors often elaborate selling
mechanisms in the absence of regulation
Also, a statistical analysis of stock market
indexes shows low correlations which is
partly explained by the hazardous political
environment and lack of development in
Latin America
Therefore, we hypothesize that the
development of short sales is a determined by
the maturity of markets
Regulation should come as a way to regulate
trading activities were markets are mature
Discussion and Conclusions
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Global capital flows are one of the main drivers determining
the depth of Latin American capital markets
Market liquidity allows investors to balance risk and return,
which is essential for the integration of short sales in portfolios
strategies
The evaluation of short selling policies is complicated in Latin
America where markets are inefficient
The comparison between developed and Latin American
markets allows to bring interesting hypotheses:
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In developed countries, it is possible to evaluate correlations of
stock prices, build efficient portfolios and compare their returns
to risk free returns
 In Latin America, correlations are strongly biased depending on
political and economic events
 Therefore, in less Latin American economies sovereign risk
becomes the most evident variable to evaluate against return
Further thoughts
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It would be worth studying global portfolio strategies
involving several securities within different Latin American
markets to help increasing the understanding of this topic
It is worth noting the lack of public statistics to provide any
reasonable quantification of short selling in Latin America
We believe that theory about short sales in Latin America is
not complete. This short article intended to contribute to the
creation of theoretical grounds in this topic