By Phil Mackintosh, Chief Economist, Nasdaq
The meme stock activity back in January 2021 shined a light on short selling, spurring an SEC report and new SEC and FINRA rule change proposals.
But what is interesting when we look at the data is that short interest was actually declining well before the MEME stock squeeze happened.
What’s the difference between short selling and short interest?
Short selling happens when a trader sells a stock they don’t already own. It’s done by borrowing shares of that stock and (effectively) selling the borrowed shares in the market. When the short seller closes their position, they buy back the stock. The shares received in settlement are returned to the stock lender, and collateral on the loan is returned to the short seller.
Short interest represents the total amount of shares shorted. Regulators require total short shares held in each security to be disclosed twice every month. Because not all companies are the same size, just looking at total shares doesn’t allow good comparisons. Instead, we typically compare short interest ratios that either look at shorts as a percentage of float shares outstanding (short float) or average daily liquidity (days to cover).
Today we take a look at short interest as a percent of shares outstanding (short float) over time.
Short interest in decline
Over the last decade, median short interest levels have been relatively constant. For example, the typical (median) short interest in S&P 500 stocks has ranged from 1.6% to 2.9% (blue line in Chart 1).
Despite that tight range, short interest ratios peaked in March 2016 for all company size groups and have since been generally declining. Interestingly, S&P 500 short interest fell fastest right after COVID-19 lockdowns, dropping to around 1.6% during 2020, which is roughly where they sit today.
Chart 1: Short interest has generally declined since 2016
Some of the short interest in S&P 500 stocks is required to maintain arbitrage. S&P 500 stocks make up the most liquid ETF in the U.S., as well the futures, which trade even more than the whole stock market with significant open interest. There are also liquid options markets on the S&P 500 index as well as swaps. Some amount of shorting of stocks is required just to hedge arbitrage positions against those index products.
Given that, it is interesting the typical short interest in large-cap names is around half the normal levels of short interest for mid- and small-cap stocks throughout the period. Small- and mid-cap short interest also remains above record lows for the period in Chart 1.
What about the most shorted stocks?
Of course, the meme stock trading in January 2021 was, initially at least, focused on a few very high short interest stocks. GME initially had close to a 100% short interest ratio, although as we explained, that’s not as short as it sounds.
In Chart 2, we focus on the average short interest of the 10 most heavily shorted stocks in each group. That shows a dramatic drop in the most shorted stocks in January 2021, likely impacted by the meme stock short squeeze. For example, short interest in mid-cap stocks, which includes the majority of meme stocks, fell from 60% to 25% in just weeks.
Chart 2: Average short interest for 10 most heavily shorted stocks (in each group)
It’s also interesting to compare the left axis on both charts. The most shorted stocks have much more of their market capitalization held short compared to the typical level across all stocks. For example, the most shorted S&P 500 stocks now have an average short interest of 11% of shares outstanding, compared to 1.6% for the median stock (in Chart 1). That also suggests that short sellers focus mostly on just a few stocks.
Regulators spring into action
As markets sold off due to COVID, multiple countries banned short selling in some stocks, despite research that consistently shows that short selling bans are bad for the market – spreads widen and liquidity falls. Sometimes the inability to hedge actually makes the market selloff more than when short selling is allowed. At the time, the U.S. resisted, with former SEC Chairman Jay Clayton saying, “We shouldn’t be banning short selling; you need to be able to be on the short side of the market in order to facilitate ordinary market trading.”
However, the meme stock trading in January 2021 refocused regulators – specifically on stocks with high short interest. Since then, regulators have put forward numerous new investigations and proposals:
- The DOJ is reportedly investigating professional investors, looking for signs that some firms may engineer stock drops or engage in insider trading.
- The Financial Industry Regulatory Authority (FINRA) has proposed more frequent reporting to the public of short interest data it collects. FINRA suggests moving Rule 4560 from the current twice a month to weekly or daily, as well as shortening the time for submitting and publication of short interest data to the public.
- FINRA has also proposed collecting additional account-level data, including synthetic shorts (those using derivatives), loan obligations from borrowing shares, and daily fail-to-deliver positions. However, that’s expected to be for their own Regulation SHO surveillance, not a public
- The SECs GME report concluded that “improved reporting of short sales would allow regulators to better track” the interplay of shorting, and short covering, on prices.
- The SEC proposed a shorter settlement cycle. By amending Rule 15c6-1, the settlement period would decrease to T+1. This would reduce fail-to-deliver positions from a short sale closeout date to T+2.
- In 2021, the SEC proposed what is essentially a “tape” for stock loans. Known as Exchange Act Rule 10c-1, it would require all loans in a security to be reported within 15 minutes to FINRA – including details like issuer, ticker, time, venue, amount loaned, securities lending fee, other fees, collateral used, and the type of entity the borrower is. Information on securities available to and on loan would be required at the end of the day; it would be aggregated and made public the next business day by FINRA.
- The SEC has also voted to amend the CAT plan to require CAT reporting firms to report “buy to cover” information to CAT, including indicating where shorts were bona fide market making exception under Regulation SHO.
- Last week, the SEC proposed a new short position disclosure rule. Proposed Rule 13f-2 and the corresponding Form SHO would require institutional investors to report short positions to the SEC on a monthly basis (14 days after the end of each month) if their gross position was larger than $10 million. The SEC then would make aggregate data about large short positions, including daily short sale activity data, available to the public for each individual security.
The latest SEC proposal is somewhat similar to what happens in Europe, where hedge funds are required to report short positions once they short more than 0.1% of the shares outstanding, decreased from 0.2% in January 2022, where data is made public when shorts exceed 0.5% of shares outstanding.
Interestingly, this is still not consistent with how U.S. investors report long positions, which are mostly reported each quarter, by account, on Form 13F. Although, the SEC has also proposed to broaden U.S. long position reporting to “look through” swap positions, which is similar to FINRAs proposal about including synthetic shorts in their data collection.
Shining new light on short sellers
Although research suggests that short sellers provide important price discovery and liquidity to the market, recent trading activity has prompted both FINRA and the SEC to propose more granular and frequent short selling reporting.
These rules aren’t yet final, but the fact that they have been proposed marks a change from historic short selling rules – even as total levels of short selling are in decline.
