image description

Reality Check

by Michael W. Stocker and Adam Reed
The Deal Pipeline |
The ongoing quest for reform in market regulation, fueled by the financial panic of 2008, has thus far resulted in more questions than answers

The ongoing quest for reform in market regulation, fueled by the financial panic of 2008, has thus far resulted in more questions than answers. However, suggestions for at least one kind of reform have recently drawn increased attention: the tighter regulation, or outright prohibition, of short-selling. At a scrutinized hearing April 8, the Securities and Exchange Commission unveiled a series of proposals aimed at controlling short-sellers more closely, an effort to stem abuses some see as contributing to the recent market collapse.

A brief look at the history of short-selling regulation and its intended and unintended consequences suggests the proposed reforms should be considered with great caution.

Systematic short-selling regulation in the U.S. dates to the Great Depression. The stock crisis of 1929 resulted in the imposition of an "uptick rule" aimed at preventing short-sellers from exacerbating stock declines.

The uptick rule, which the SEC promulgated in 1938, permitted short sales only when the last sale price was higher than the previous price -- effectively limiting short-selling to stocks whose prices were rising at least on a trade-by-trade basis.

Although the uptick rule remained in place for decades, many analysts doubted whether it was necessary and effective. To test these concerns, the SEC in 2004 suspended the rule for one-third of Russell 3000 Index stocks, while leaving the rule in place for the remainder of the Index stocks. The results of the study were surprising. Although eliminating the uptick rule increased the volume of short sales, it did not increase the overall short interest in securities.

Although these studies were conducted in a less volatile market, they did call into question whether the uptick rule actually had any impact in preventing the supposed abuses that it was intended to address. In response to the study, the old uptick rule was eliminated in July 2007.

Despite doubts about the ability of short-sellers to effectively manipulate highly liquid stocks, the collapse or near collapse of Wall Street giants in 2008 saw a resurgence of interest in more tightly regulating short-sellers. By June 2008, a movement to reimpose short-selling regulation had reached critical mass, and a the SEC issued series of new rules. The first was an emergency order directed at naked short-selling of 19 stocks, requiring that short-sellers actually have the stock they plan to sell short in hand three days earlier than they needed to previously.

In his 2008 remarks, former SEC Chairman Christopher Cox explained why he saw the practice of naked short-selling as especially deserving of attention. He urged that because naked shortsellers do not actually borrow the stock they sell, and fail to deliver the stock to the buyer, they might be able to drive share prices down far more than legitimate short-sellers. Cox, however, was careful to point out that legitimate short-selling plays a key role in factoring negative information about business prospects into share prices, helping prevent asset bubbles and irrational exuberance in the markets.

In September, still more rules were issued, including a ban on short-selling of certain financial stocks that applied to all investors except market makers, effectively restricting short-selling to those sophisticated investors who were able to implement options trading strategies -- making it much more difficult to fail to deliver. The SEC also issued a rule specifically penalizing fraudulent short-selling.

A new study suggests the imposition of these rules had important -- and unintended -- consequences for the market. While the emergency order and the ban appear to have reduced the volume of naked short-selling, they were both associated with significant declines in market quality (Kolasinski, Reed and Thornock, "Prohibitions versus Constraints, the 2008 Short Sales Regulations," University of North Carolina Working Paper).

Because the rule changes consisted of several distinct components, it is hard to determine which changes drove these effects.

Although the ban on short-selling of financial stocks was lifted less than a month after it was imposed, Cox has come to regret the ban, remarking that in retrospect, the costs of the shortselling ban outweighed its benefits.

These unforeseen consequences of short-selling regulations clearly weigh heavily on the SEC. In the April 8 hearing, the SEC proposed alternative forms of restrictions on short-selling -- two different versions of the old uptick rule abandoned in 2007 and a "circuit breaker" rule, which would only impose restrictions on short-selling if there is a sudden and sharp decline in a company's stock price.

At the hearing, Commissioner Troy Paredes warned against any rush to condemn short-selling, pointing out that the practice is an important source of information for investors. He urged that stock prices must reflect not only positive assessments of a company's prospects, but negative opinions as well, and he warned that adopting restrictions on sales may result in a decline in the market's confidence in the accuracy of stock prices.

Commissioner Luis Aguilar warned that if short-selling is restricted too sharply, market participants might resort even more to swaps and other devices in unregulated markets that the SEC lacks power to control.

The commission's decision to carefully consider its options is well founded. In considering the future, the commission would be wise to look first to the past.