The Unpriced Information in Fail-to-Deliver Short Sales : Implications for Regulation and Identifying Limited Arbitrage

Fail-to-deliver (FTD) short sales occur when shares sold on trade day t are not delivered on settlement day t+3. FTDs can occur for a variety of reasons but generally indicate that short seller demand for shares exceeds the supply of shares available for loan. This study investigates whether the amount of FTDs provides equity valuation information and whether the information is in the current period’s stock price. If valuation information is unpriced, this would indicate that a supply/demand imbalance in shares available for loan has limited short arbitrage. First, we find the level of FTDs is associated with fundamentals that have been shown by prior research to have information to predict stock prices. Second, we find that stocks with higher FTD levels experience more negative future stock returns, indicating that shorts have unpriced valuation information. The negative returns continue in future months, so the information is incorporated into stock prices slowly. Much of the unpriced information is due to a high proportion of stocks on “special” (expensive to borrow). Notably, the unpriced information in FTDs exceeds that in covered (delivered) short sales (CSS). This evidence shows that FTDs are more price informative than previously known, so regulators may want to exercise caution in adding to the cost of short selling to prevent FTDs. In academic research, the valuation information in the CSS and FTD components of total short interest should be considered separately. Importantly, the level of FTDs provides a publicly available (daily) proxy that can be used to identify stocks that are mispriced due to constraints on short arbitrage