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The SEC’s Plan To Restrict Short Selling at Trader’s Narrative

The SEC’s Plan To Restrict Short Selling

The SEC has recognized that the present rules for short selling haven’t worked out that well. It doesn’t take a genius to recognize that rampant naked short selling exacerbated the crisis, especially within the financial sector. The most egregious example is Bear Stearns but many other well known Wall St. investment banks saw their shares pummeled mercilessly late last year. As usual, the SEC is playing catchup. But if it acts intelligently it may still benefit everyone by creating a more stable, fair and balanced market.

As a consolation, any changes to the present rules won’t be sprung on traders as a surprise. We are presently in a 60 day consultation period, after which when or if a decision is made, it will be implemented after 3 more months to give everyone involved plenty of time to prepare. There are five possible options:

The first suggestion is to bring back the uptick rule that we have known so well over the past 70+ years. This was implemented in 1937 as a result of rampant manipulation of the market by wealthy speculators (the precursors to hedge funds) during the roaring 1920’s. It was eliminated July 3rd 2007 with little fanfare; The Uptick Rule: Nice Knowing You.

The disadvantage with the uptick rule was that it was easily circumvented by those that count. That is pro traders, institutions, etc. As always, in the end, the retail trader was left out in the cold while those with insider knowledge and more resources simply side-step the rules and sold short despite the uptick provision. Another disadvantage is that the market has become faster and more fragmented so it is getting harder to determine what exactly the immediate last price was. The advantage is that the uptick rule is well known to all market participants and it would be psychologically easy to simply revert back to them (or circumvent them, depending on who you are).

The second suggestion is to slightly modify the old uptick rule by making it more stringent: a short sale could only take place if the stock price traded at least a penny higher than before. I’m not sure what this slight ratcheting up of conditions really accomplishes. I suppose we could say 2 cents, 5 cents, and so on. In the end we’re really talking about a similar restriction to the old uptick rule with the same advantages and disadvantages.

The third suggestion is to introduce a restriction in trading only if a stock price experiences a decline of, say, 10% in a day. The simplest of these “circuit breaker” type suggestions is a blanket ban on short selling a stock that falls 10% within a trading session. This would be similar to limit days in commodity markets. Although, under this condition, the stock price could very well continue to fall much further than 10% - it simply couldn’t be pushed by short sellers.

The fourth suggestion is to soften the circuit breaker idea by just re-introducing the uptick rule for the remainder of the day if a stock falls 10%. So rather than no short selling at all, you could sell a stock short as long as it met the uptick conditions.

The fifth suggestion is to introduce a “bid test” if a stock falls 10% (in a trading session). This would mean that a short sale could occur only if it takes place at the highest available bid and not just an uptick.

My hunch is that if the SEC goes with any of the circuit breaker ideas it will introduce them in staggered fashion rather than in one fell swoop. There are two main perspectives on this sort of thing: leave the market alone and to regulate heavily. I fall somewhere in the middle. The trick is that while we do need to interfere with the market, it has to be done intelligently and minimally.

I can’t understand those that want a completely free market. We are constantly interfering with the systems that we live in. We have laws (that are constantly changing and adapting), we have police and courts that react to our behaviors and actions, etc. How is the stock market different?

The problem is when regulation is done with a sledgehammer it becomes outright intervention, which is at best useless and at worst, disastrous. If the SEC takes this short selling restriction too far, it won’t stop the practice but simply force it to take place in different forms and in different places. For example through swaps or other unregulated dark corners of finance.

Take a look at the Karachi stock exchange chart below to see what happened when the government of Pakistan put an artificial floor on prices:

karachi index government intervention Apr 2009

Obviously a government mandated floor for stock market prices doesn’t work. And recall how last year, the SEC along with the equivalent regulatory body in the UK (the FSA) halted short selling from September 19th to October 8th 2008. Although it originally covered mainly financial and bank stocks, it was quietly expanded to include other companies as well. In the end, it had really as much effect as standing in front of a runaway freight and yelling ‘STOP!’.

But that doesn’t mean that we should throw our hands up and do nothing. Everyone involved with the market knows that naked short selling is a problem. It shouldn’t be allowed because it undermines the integrity of the stock market. If the SEC can put a stop to the abusive short selling practices it would go a long way in restoring confidence in the stock market. That would be much more productive than ruminating about the minutia of short sale restrictions.

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6 Responses to “The SEC’s Plan To Restrict Short Selling”  

  1. 1 Jo

    Ok so these clowns are really trying to trash the market.

    Why not do the brave thing and address the real problem: naked short selling? Go after the non-deliveries….oh g’wan, g’wan,g’wan.

  2. 2 John Forman

    I’m with Jo. You mentioned naked short selling in your first paragraph as a major (the major?) culprit yet not one of the suggestions put forth addresses that at all.

  3. 3 Trader Joe
  4. 4 YW

    I don’t know if “rampant naked short selling” exacerbated the crisis or whether there were the “value blind baloon inflators euphorianist” that did it…

  5. 5 Colin

    And maybe we should put these same restrictions on buying when we go up. Oh wait, I forgot, this isnt about properly regulation markets. These concepts are outright manipulation. Naked short selling is a problem, that is all. Everything else and we might as well start mandating 0.5% growth each day.

  6. 6 Babak

    Colin, the equivalent restrictions would be the ability to buy something when you don’t have the capital or the wherewithal or the intention to ever complete the transaction. That (in a mirror) is what naked short selling is.

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