By Keith Fitz-Gerald
Money Morning/The Money Map Report
Earlier this week, the U.S. Securities and Exchange Commission (SEC) announced new cmeasures designed to reign in so-called abusive “short-selling” of stocks by forcing “short-sellers” to actually deliver the shares of companies they’re shorting. Now the SEC has taken an “emergency action” and temporarily halted short selling on 799 financial companies.
Talk about shutting the barn door after the horses have bolted …
Still, this issue is worth a closer look.
A Short Course on Short-Selling
Short selling, in case you’re not familiar with it, is essentially a bet that a stock is going to drop in price. Traders borrow shares they don’t own and sell them, reaping the proceeds from the sale. If the price drops, the trader then buys the shares back at the lower price, repays the loan of the shares, and pockets the difference.
As an oversimplified example, let’s say that a stock is trading at $20, and a trader is certain it’s going to drop. He borrows 1,000 shares, and sells them, generating $20,000 in proceeds (not factoring in commissions). The stock drops to $10. So the trader goes back into the market, buys 1,000 replacement shares, spending $10,000. The $10,000 difference is the trader’s profit ($20,000 in proceeds from the short sale minus the $10,000 spent to replace the shares equals the profit of $10,000).
For the last 70 years, a trader had to wait until the stock moved higher before he could short it. More formally known as Rule 10a-1, the uptick rule actually came into existence in 1938, after an inquiry into the concentrated short selling that took place during the collapse of 1937, an event that is beyond living memory for all but a few traders.
Under Rule 10a-1, a listed security could only be sold short at a price above the price of the immediately preceding trade. In other words, it had to “uptick,” which is trader slang for a stock moving higher before it could be shorted or taken lower. There were, of course, a few exceptions, but the gist of the matter was that the rule helped maintain orderly markets by restricting unlimited wholesale selling.
This all changed last year.
Undoing the Uptick Rule
On July 6, 2007, in its infinite wisdom, the SEC eliminated the so-called “uptick” rule. Citing a 2004 study by the SEC’s Office of Economic Analysis, academic researchers concluded that the uptick rule “modestly reduced liquidity and does not appear necessary to prevent manipulation,” the SEC rescinded the order.
Since that fateful ruling, as a look at any trading chart will show you, the markets have largely been on a one-way trip – South. That’s led the SEC to conclude that it didn’t like the fact that – absent the uptick requirement – investors and traders can utilize unlimited short orders any time they feel like it. In short, they realized they opened the door to the abusive short-selling of stocks.
Ostensibly, the SEC is worried about price manipulation and so-called “short attacks,” where hedge funds and other investors can boost their own short-selling profits by ganging up on weak companies and driving their prices lower.
While I laud the SEC’s concerns, the current rule change is both a day late, and about $2 trillion short.
It’s not like SEC’s experts didn’t see this coming and it’s not like potentially unlimited short selling was some sort of revelation after the dust settled two days ago. SEC insiders had to know this was happening. What’s more, they’ve known it was going to happen – since 1938.
Still, as we study the fallout from this past week’s near-collapse of the financial markets, it’s worth looking at the newest changes as they affect short selling.
The Short-Selling Ban
Yesterday (Friday), the SEC issued an emergency order banning the short selling of 799 individual stocks through midnight Oct. 2. The SEC reserved the right to extend the ban, but promised it would not stay in place longer than 30 days.
In the United Kingdom, the Financial Services Authority put a similar ban in effect on Thursday.
The SEC said the move was needed "to protect the integrity and quality of the securities market and strengthen investor confidence."
"The commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets," said SEC Chairman Christopher Cox, according to a MarketWatch report.
"The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets. This action, which would not be necessary in a well-functioning market, is temporary in nature and part of the comprehensive set of steps being taken by the Federal Reserve, the Treasury and the Congress," he added.
In addition to the ban, the SEC has also required money managers to disclose their short positions in the securities affected by the ban. The securities agency also eased restrictions in order to make it easier for a securities issuer to re-purchase its own shares, which the SEC feels will restore liquidity to the market.
A Day Late and $2 Trillion “Short”
In my view, the SEC is acting now because it wants to appear as if it is doing something – anything – to counter the riptide that’s sending our collective national wealth out to sea. That way the agency can claim it has taken steps to “fix” the problem, and perhaps duck some blame when the recriminations start flying and the lawsuits get launched – once the inevitable political post-mortem gets under way on the capitalist cadaver that was once our financial-services sector.
Traders have been waging “short-attacks” for years and, in the past, the SEC has been nearly powerless to stop them. And no matter how much regulation they put in place in the future, I have a hard time imagining that they will be anything more than a deterrent at best.
All it takes is a little misinformation, a few half-truths or some well-placed lies disguised as tips circulated in the trading pits, or (better still) over the Internet to get the rumor mill cranked all the way up. Factor in trading volumes and some of the games that traders can play with the retail public and all hell ding volume and the games traders can play with the retail public and all hell breaks lose in short order – much to the delight of the guys who are “net short” the target.
While there is still a lot of information that must be digested, my initial reaction to these new anti-shorting rules is that I am more concerned with the unintended consequences that they may have – consequences no one’s even considered, yet.
For example, one of the SEC’s new rules requires actual delivery of shorted shares. While that would seemingly nip things in the bud by requiring traders to actually have the shares ready for delivery, it may interfere with market makers who frequently use shorted shares and put options to hedge their portfolios.
And this could actually introduce more volatility into an already fractured marketplace.
On a related note, by requiring delivery on all shorted shares, the new anti-shorting regulations essentially require traders to “pre-borrow” shares of the stocks they want to short or hedge. And professionals are not in the business of hedging that kind of risk on top of the trade risk they already take on as part of the daily grind. Which means they may elect to change their trading habits, which could also alter current risk levels in an already risky environment.
Am I being a little too cynical? I don’t think so.
This is yet another example of too little, too late from regulators who have been completely asleep at the wheel, and an industry that has proved itself to be hopelessly incapable of self-restraint.
In the weeks ahead, we’ll undoubtedly discover where more bodies are buried. The only question to answer then will be just how big the graveyard actually is.
News and Related Story Links:
The Government’s Financial Crisis Fix-it Plan Sends Stocks Soaring, Though Some Argue There’s no Quick Fix for this Disaster
SEC bashed over short-selling ban
SEC bans short selling hundreds of financial stocks
About the Author
Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean, and he's also the founding editor of Straight Line Profits, a service devoted to revealing the "dark side" of Wall Street... In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.