Are Financial Market Corners and Short Squeezes Inefficient

Abstract

This paper rigorously examines the prevalent belief that financial market corners and short squeezes reduce trading efficiency, especially when traders are privately informed. Explicit welfare criteria are proposed, and a trading model based on direct revelation mechanism design methodology is developed. It is shown that market corners and short squeezes are not per se inconsistent with trading efficiency if traders are sufficiently risk-averse. An impossibility theorem is then proved: The risk-aversion levels that give rise to corners in the first place can never be large enough to achieve efficiency starting from those corners. Increasing the supply of the traded security can restore efficiency, while neither limiting the short positions nor preventing the cornerer from squeezing the shorts improves trading welfare. These results hold for any set of prior beliefs, and for any trading game that shares the same preferences and information structure – direct or indirect, extensive-form or normal-form, with or without trading frictions.