Next Tuesday, the Securities and Exchange Commission will host a series of roundtable discussions about the prospect of new short-sale restrictions at its offices in Washington, D.C.
However, attendees of a panel discussion on Thursday by the Security Traders Association of New York may have gotten a preview of what’s in store for the roundtables. Several industry executives argued that reining in short selling would not stop downward pressure on stock prices. Instead, they said, it would be counterproductive and would make the markets less efficient, thereby hurting investors.
William O’Brien, CEO of Direct Edge ECN, was the most vocal. He argued that reintroducing price tests or adding a circuit breaker to the market would damage the quality of the equities market. Restrictions around short selling “will drive volume out of the market, widen the spread, and be, effectively, a silent tax on every trade,” he said. The reason is that short-sale restrictions could reduce statistical arbitrage and other types of trading that require short sales, resulting in less trading and wider spreads.
Earlier this month, the SEC put forward a proposal detailing five options to limit short selling. Two are based on price tests and three involve circuit breakers. The circuit breakers, once triggered for individual stocks, would lead to restrictions around short sales in those stocks.
The SEC’s two price tests include a reintroduction of the Big Board’s old uptick rule, which operated from 1938 through mid-2007, and a bid test similar to what was in place on Nasdaq from 1994 until mid-2007. Two years ago, the SEC removed all price tests limiting short selling. The SEC did this after several years of analysis and a pilot study involving about 1,000 stocks, whose results indicated that the removal of price tests would not adversely affect the markets.
Richard Lindsey, CEO of Callcott Group, a quantitative consulting group based in New York, called the current outcry against short selling by politicians “political theater.” Lindsey is a former director of the SEC’s Division of Market Regulation (now called the Division of Trading and Markets). He ran that division from late 1995 until early 1999. Prior to that, he was chief economist at the SEC.
Members of Congress, Lindsey said, are blaming short selling for the rapid price declines last fall in a bid to appeal to investors and corporate boards. The former regulator said he had started the process of getting rid of the short sale rule in 1996 when he was at the SEC.
“I didn’t believe in a short-sale rule then, and I don’t believe in a short-sale rule now,” Lindsey told the trading industry crowd. He added that if the SEC is going to change a rule that took a decade to remove, it should be able to describe the detrimental effect short selling had on the market. The impulse to remove it, he said, should not come from “hand wringing.”
Michael Whitman, CEO of Stuyvesant Trading Group, an options market-making firm, agreed. In his view, the push by investors and politicians to reinstate the uptick rule or some version of that rule is a “response to populist anger and doesn’t serve a purpose.” He said it’s easy for politicians on TV to “point to the uptick rule as a panacea” to declines in individual stock prices. He told the audience that the equities markets functioned well last fall, compared to other asset classes, and “for us to pay the price now feels counter-intuitive.”
Direct Edge’s O’Brien echoed that sentiment. Investors may not have liked the prices they saw on the screens of the stocks they owned last fall, he said, but they were able to sell easily when they wanted to unload a position or cut their losses.
The traditional defense of short selling is that short sellers provide a counterweight to optimistic views of companies and reveal shortcomings that other investors may be reluctant to see. Short sellers also provide liquidity to buyers of stocks. A paper called “It’s SHO Time!” forthcoming in the Journal of Finance, notes that in 2005, 24 percent of NYSE-listed volume involved short selling, while 31 percent of Nasdaq-listed volume was the result of short selling. Comparable figures for subsequent years were not available.
The argument against short selling is traditionally an argument against abusive short selling in which market participants deliberately try to push down the price of stocks. This typically involves naked short selling. Investors engaged in naked shorting usually do not intend to borrow the shares required to settle their short transactions. This results in “failures to deliver,” which the SEC in recent years has worked to reduce. It introduced strict penalties for fails last fall in the midst of the financial market turmoil.
With the prospect of new short-sale trading restrictions on the table, O’Brien on Thursday charged the New York Stock Exchange and Nasdaq with “pandering to their listings community rather than providing leadership.” Many issuers have traditionally supported restrictions for short selling. The exchanges are appealing to issuers, O’Brien said, by endorsing a bid test. In his view, neither exchange wholly supports the idea of restrictions around short selling.
The NYSE favors a bid test over a tick test, said panelist Colin Clark, vice president for strategic market analysis at NYSE Euronext. He noted that the SEC itself has expressed concern about the latency of last sale information for some market participants.
“The New York Stock Exchange is operating under the assumption that something is going to be done,” Clark said. The exchange’s goal is therefore advocating for an outcome that is “reasonable and implementable.” He pointed out that in addition to the question of which price test may be better, the other broad issue up for debate is whether a price test should be applied all the time or only in periods of market stress.
Jeromee Johnson, vice president for market development at BATS Exchange, said his exchange, like the New York, supports a bid test. He noted that it was “the least bad of many bad alternatives.”
The BATS view, Johnson made clear, is a pragmatic one. “If we do not put forward an acceptable alternative, we run the risk of Congress, [CNBC commentator James] Cramer, or whoever coming in, lighting a match and burning down the forest,” he said. He added: “If we are going to have restrictions on short selling, we’d like those restrictions to be as little and as light as possible.”
When pressed to say whether a new short-sale rule is needed, NYSE’s Clark noted that “in certain situations a rule would not hurt.” Johnson of BATS said “no.”
The NYSE, Nasdaq and BATS sent the SEC a letter in March proposing a bid test with a circuit breaker. Under that proposal, short sellers would only be able to add liquidity at a price above the national best bid once the circuit breaker was triggered. The exchanges could create order types to facilitate this, the letter said.
The SEC, however, did not include the exchanges’ recommendation in its proposal, which it published for comment several weeks ago. The SEC’s bid test option is less restrictive than what the three exchanges suggested, since short sellers under the SEC’s bid test would be allowed to execute on an upbid, but without being restricted to just adding liquidity.
Many of the largest broker-dealers are keeping mum on their positions regarding a reintroduction of short-selling restrictions. Some are reluctant to speak publicly about their views. Credit Suisse, however, has come out against new restrictions.
Dan Mathisson, head of the firm’s Advanced Execution Services group, told Traders Magazine on Friday that restrictions around short selling would likely impair liquidity and increase market volatility. At the same time, he noted, the SEC’s version of a bid test would be more complicated for brokers to implement than the version the exchanges suggested. “Tracking the sequence of bids is difficult since they may arrive out of order,” he said. “The implementation of a strict bid test in a fragmented environment would be extremely complex.”
In his panel comments, Direct Edge’s O’Brien also discussed the circuit breakers in the SEC’s proposal. He noted that in the market turmoil since last fall, stocks have risen and fallen by 10 percent frequently. That means, he said, a circuit breaker could be triggered often, leading to potential changes in trading behavior in stocks that decline significantly.
A Credit Suisse report from last Thursday provides data about how frequently stocks moved down by 10 percent or more last year. The report, “Ticking Off the Shorts,” outlines the SEC’s current short-sale proposals and includes volume, spread and short-interest data related to short selling since last summer. (The report can be accessed here.)
According to Credit Suisse’s data, a 10 percent circuit breaker would have been triggered 26.6 times per day for Standard & Poor’s 500 stocks last September, and 80.4 times per day in October. In November and December, it would have triggered 48.8 and 25.0 times per day, respectively. That compares to the first eight months of 2008 when the average number of times per day that an S&P 500 stock dropped 10 percent ranged from 0.8 to 7.7.
The SEC, O’Brien argued, is pushing for changes in the wrong place. He noted that instituting brakes on short selling would not restrict the abusive short selling that drives down prices. That abusive behavior, he said, takes the form of naked short selling and can be seen in the fails rate.
The Direct Edge exec advocated greater transparency about short transactions and synthetic short positions (such as through options, credit default swaps and exchange-traded funds) for money managers and trading firms. In addition, O’Brien said, more-stringent enforcement of locate and delivery requirements for short sales should be introduced. The SEC last fall imposed several temporary rules in both of these areas. These rules expire this summer but are widely expected to be renewed in some form.
