Abstract: One question that has plagued regulators for a long time is that the volatility in the stock market has always been increased when short selling bans are removed. With the perspective of financial system engineering, the state space approach that takes into account the effect of behavior factors on the complex system, can help us decompose the price return into three parts:the innovation shock, the investors' reaction to the innovation shock, and the noise. This approach deepens our recognition and consideration about the question theoretically. Empirical result shows that short selling significantly increases the speed of investors' reaction to innovations and decreases the ratio of noise in the return volatility. This result indicates that the increased volatility comes from the increased speed of investors' reaction to innovations and therefore is the natural result of the development of stock market. The paper confirms the substantial improvement on price discovery efficiency induced by short selling in the Chinese stock market.

Key words: financial system, state space approach, behavior factor, short selling, price discovery efficiency