When market crashes happen, there is always some politician who blames "speculation" for the fall in share values. Specifically "short-sellers" are blamed. This is where stock is lent (for a fee) to someone, who then sells it hoping to buy it back later at a lower price, pocketing the difference.
By banning this process, governments hope to stop the markets falling so fast. However it doesn't work.
- It signals panic, causing long-only investors to sell out
- It causes the unwinding of pairs trades (where you go long for example Barclays and Short RBS) - this means buying RBS and selling Barclays.
- It forces buying of the bad stock, which often has to be paid for by sales elsewhere.
- by removing a significant chunk of the market's power to signal the correct price, volatility often increases.