The U.S. Securities and Exchange Commission, early this morning after 12 a.m., took unprecedented emergency action to prohibit all investors and firms from effecting short sales in 799 financial stocks. The temporary ban on short-selling was effective immediately and continues through October 2.
SEC Chairman Christopher Cox said in a statement issued during the night that the Commission took drastic action to interfere with the functioning of the securities markets to provide a “time-out to aggressive short selling in financial institution stocks.” This grave time-out was needed, he said, “to combat market manipulation that threatens investors and capital markets.”
The short-selling ban for financial stocks, along with efforts last night by the U.S. Treasury Department and Federal Reserve to shore up the financial system, led markets to surge this morning on tremendous volume. The floor of the New York Stock Exchange was a hive of activity at the open, with 650 million shares trading on the exchange in the market’s first 10 minutes. Morgan Stanley, Goldman Sachs and other financial companies battered by bearish investors in the last few days found resurrection today. Morgan and Goldman were each up close to 20 percent in the first hour and a half of trading. NYSE Euronext, the parent company of the NYSE, told reporters it is working with regulators and is “committed to ensuring fair and orderly markets of the highest quality.”
“Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets,” Cox noted in the announcement accompanying the ban early this morning. “At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.”
The SEC said it was allowing a “limited exception [to the short-selling ban] for certain bona fide market makers.” The Commission noted: “We believe this narrow exception is necessary because such market makers may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the requirements of this Order.” Registered market makers, block positioners and over-the-counter market-makers are excepted from the requirements of the SEC’s ban.
To facilitate the quarterly expiration of options, all options market makers are excepted from this ban on short-selling for today. This exception ends at midnight.
After today, options exchanges are likely to be significantly impacted by the inability of options market makers to short stocks. “Although we believe the SEC’s action will have an impact on the quality of the options market for those names covered by the Emergency Order, we understand the SEC’s decision to take this step on a temporary basis, given the unprecedented volatility and stress that the market is experiencing,” Gary Katz, president and CEO of the International Securities Exchange, told Traders Magazine early this morning.
William Brodsky, chairman and CEO of the Chicago Board Options Exchange, issued a sharply worded statement in mid-afternoon nothing that the “need for the policy intervention notwithstanding, it is difficult to comprehend the merits of a draconian measure that will result in the sudden and severe removal of liquidity from the marketplace at the same time that the government is taking unprecedented steps to preserve it.”
Investors, Brodsky said, “rely on a deep and liquid options marketplace in which to safely hedge and to transfer risk in times of market turmoil, yet this action will severely compromise the ability of [options] market makers to make markets.” He went on to note: “Liquidity in the affected stocks will suffer to the extent that market makers are hampered, and–absent relief–market makers will be hamstrung. The lack of relief for options market makers will have serious ramifications for the reliability of the options market and for the efficiency of our capital markets overall.”
John Coffee, a professor at Columbia Law School, said he hoped the Emergency Order would restore some equilibrium in the markets and make further prohibitions unnecessary. “Because option market makers will not be able to sell short in this period, liquidity in the option markets will likely be constrained,” he said. In general, he added, “short selling may exacerbate price declines and volatility, but the fundamental problems with investment banks, including high leverage and excessive investments in real estate, are probably much more responsible for their current problems.” However, he observed, in the throes of an emergency the SEC “is probably justified in taking an emergency measure.”
Steve Sanders, senior vice president for business development at Interactive Brokers, a large broker-dealer whose subsidiaries make markets in stocks and options, said: “At this point, our interpretation is that we’ll be able to short stocks as an equities market maker. That will help our ability to continue to make markets in options.”
Dan McCabe, CEO of Next Investments, a company that designs exchange-traded funds and other structured products for banks and brokerage houses, said a key problem with the large short-selling market lies in how the securities lending industry works. “The No. 1 thing to be addressed is the stock loan market,” he said. “When that market’s glaring lack of transparency is addressed and the actual cost of a borrow comes in line with the value of that borrow, it will dampen market volatility.” The stock loan market provides shares to investors and firms selling borrowed stocks short so they can settle their short-sale transactions.
“The SEC’s temporary ban was necessary,” McCabe said. “The rule should be ‘One stock, one short,’ and the beneficial owner of that stock should receive the payment for the loan [rather than intermediaries]. You shouldn’t enable people to get leverage through multiple borrows and then allow them to fail to deliver shares for their short sales.” McCabe previously ran the specialist firm Bear Hunter Structured Products, which was owned by Bear Stearns.
Michael Plunkett, president of broker Instinet, agreed that the stock-loan business was one of the short-selling culprits, noting that some broker-dealers “lent out the same shares to a multitude of people borrowing short-term [for short sales], knowing they’d have them back at the end of the day, so they didn’t have to decrement the actual shares.” That, he said, created additional shares that didn’t exist in those securities. He added that the SEC’s recent actions may eventually shed light on the stock-loan business, which provides hefty margins to broker-dealers lending shares.
The United Kingdom’s Financial Services Authority yesterday also imposed a ban on short-selling in financial companies, effective this morning. The FSA granted market makers a reprieve from that ban, which will last until mid-January. The SEC’s Cox said the SEC and FSA “are consulting on an ongoing basis with regard to short selling matters and will continue to cooperate in carrying out regulatory actions.”
The SEC said it could extend today’s Emergency Order beyond October 2. October 17 is the last possible date this temporary ban can be in operation. The SEC’s Emergency Orders, under Section 12(k)(2) of the Securities Exchange Act of 1934, can last no longer than 30 calendar days.
The SEC took two other actions in conjunction with today’s broad ban on short-selling. It is requiring investment firms with at least $100 million in securities to file public information about their short-selling activity. The new Form SH must be filed on the first business day of every week after a week in which the firm effected short sales. The firms must disclose the number of shares and the value of securities sold short.
This rule was put in place to track the daily short-selling activity of firms in a position to hammer the publicly traded stocks of companies. “We are concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers exacerbated by short selling,” the SEC’s order said. “We also believe that some persons may take advantage of issuers that have become temporarily weakened by current market conditions to engage in inappropriate short selling in the securities of such issuers.”
The SEC is also allowing corporate issuers to repurchase their securities within a “safe harbor” that suspends the timing restrictions and modifies the volume conditions associated with issuer repurchases. The SEC said issuer repurchases are “an important source of liquidity in times of market volatility.”
The SEC’s action this morning follows two other recent SEC Emergency Orders, one issued Wednesday and another one on July 15. Both of those orders imposed restrictions around short-selling designed to limit the ability of abusive naked short-selling, fueled by rumor-mongering, to jeopardize the viability of publicly traded companies. The July 15 order (which was in effect from July 21 through August 12) focused on 19 financial companies, while Wednesday’s order imposed restrictions on short sales in all securities. The Wednesday order went into effect yesterday and runs through October 1. It was effectively superseded for 799 financial stocks by the SEC’s Emergency Order of today, but it remains in operation for all other securities.
As part of the Wednesday order, the SEC announced a new temporary rule, called Rule 204T, to Regulation SHO. Reg SHO, the set of rules that provides a framework around the industry’s short-selling activity, went into effect in January 2005. Rule 204T levies severe penalties on clearing firms and broker-dealers whose customers engage in naked short-selling by not borrowing shares to settle their short sales on time. The delivery of borrowed shares to fulfill short transactions is required by the settlement date, which is typically three days after the trade occurs. Rule 204T went live yesterday.
At the same time, the SEC put into effect amendments to Reg SHO that eliminated the existing options market-maker exception to the close-out requirement in Reg SHO, and a stringent new anti-fraud rule targeted at short-sellers who deceive their brokers about their intention or ability to deliver shares for settlement.
The Securities Industry and Financial Markets Association issued a statement after the market closed yesterday supporting the SEC’s recent focus on abusive naked short-selling. The statement came in the wake of Wednesday’s Emergency Order and before the SEC’s early-morning short-selling ban today. “These are extraordinary times and the industry is committed to the SEC’s overall objectives of addressing abusive market practices such as illegal naked short selling and rooting-out false rumors,” Michael Paese, executive vice president of global advocacy at SIFMA said in the written comment. “Financial markets must be protected from these types of manipulation, and we support anti-fraud regulations which will ensure those who violate these rules will be punished to the fullest extent of the law.”
Paese said SIFMA is also working with the SEC “to clarify questions about the scope and application of the other short sale rules relating to the new close-out requirement, including the elimination of the [options] market maker exemption from this requirement.” He added: “We hope to solicit interpretation on several important issues in this regard to ensure our markets and the national clearance and settlement system continue to operate smoothly and with the necessary liquidity.”
Susan Milligan, senior vice president for government relations and communication at the Options Clearing Corp., yesterday said the SEC’s emergency action in mid-week jarred the industry. “The fact that the SEC announced an emergency action on Wednesday and put it in place on Thursday was a shock to everyone,” she said. The OCC is the industry clearinghouse that clears all equity options transactions in the U.S. Milligan could not be reached for comment about today’s Emergency Order.
This week’s SEC-imposed emergency changes are taking place against what is likely to be the busiest-ever week in both equities and options. U.S. equity markets yesterday hit an all-time high of 18.7 billion shares traded. Tuesday and Wednesday volumes averaged about 16 billion shares each day. Many broker-dealers also hit all-time highs. Goldman Sachs, for instance, traded a record 1.7 billion shares electronically yesterday.
In options, yesterday saw the highest-ever volume in the industry’s 35-year history, with a daily record of 30 million contracts traded, according to the OCC. The previous record was Wednesday, with 26.7 million contracts changing hands. The third-highest volume day was July 15. All four days of this week ranked among the 10 highest-volume days in options.
Although options volume did not abate yesterday, as some expected, options market-making firms began adapting to Wednesday’s new rules around short-selling. “We do have to put additional restrictions on shorting stock in hard-to-borrow securities, which requires software changes and will result in us providing less liquidity in such stocks and in derivatives on those stocks,” said David Iles, an executive at Interactive Brokers. He added: “Most of the effort will be in producing new reports detailing actions to be taken in response to pending fails, and in taking manual actions to close out failing positions.”
An executive at another market-making firm said his firm was also adjusting its processes based on the new rules issued on Wednesday. That firm, the person said, may quote in fewer options series. He noted that bid-offer spreads in some options would increase, although they would not increase uniformly across options. Other brokers agreed with that assessment, also noting that the profitability of options market makers could shrink because of additional costs associated with the new delivery obligations they are now facing.
Wednesday’s overarching SEC rule imposing penalties on firms that facilitate or allow naked short-selling to occur follows the July Emergency Order that required “pre-borrows” for short sales in the stocks of 19 financial companies names. A pre-borrow is a bona fide agreement with a broker-dealer to borrow the shares needed to settle short sales. Prior to and after the July Emergency Order, firms could sell stocks short by simply locating the shares needed for delivery. A “locate” can be accomplished by ensuring that the stock is on a broker’s so-called “easy-to-borrow” list of securities.
The Commission’s temporary Rule 204T, which went into effect yesterday for all securities and remains in place now, is broader and deeper than the July Emergency Order. It affects short-selling in all securities (although today’s Emergency Order supersedes it for financial stocks), and adds teeth in the form of penalties for firms whose customers fail to deliver securities by the settlement date. If a fail-to-deliver position isn’t closed out, the clearing firm and its broker-dealer customers cannot execute or facilitate any additional short sales in that security unless they pre-borrow the shares in advance of the trade.
Rule 204T applies to all fails to deliver for trades that occurred after the SEC’s new rule became effective yesterday. If the fail occurs because the short-seller fails to deliver the shares, the clearing agency’s customer firm processing the trade must close out the fail by borrowing or buying shares to settle the trade. If a broker can demonstrate that the fail occurred on the long side, because the holder of the shares failed to deliver the shares to the short-seller, the position must be closed out by the third day following the settlement date.
Some in the industry observed that the SEC’s stiff penalties for fails are designed to eradicate the leniency of some clearing firms toward naked short-selling by their customers. These commentators noted that all firms did not exert equally strong pressure on their customers to close out their failure-to-deliver positions.
Several industry participants also point out that the SEC’s harsh pre-borrow penalties in response to fails may compel some clearing firms to require pre-borrows for customers’ short sales, even though the SEC is not imposing that requirement on the industry. That could make short-selling activity more expensive by increasing the cost to borrow the shares for delivery. But not everyone thinks clearing firms will take such a drastic action right off the bat. Instinet’s Plunkett noted that “people don’t tend to go further than the rules require unless there’s a high level of fear in the market.” That fear, however, may now be present.
