On Wednesday's split 3-2 vote along party lines, the Securities and Exchange Commission approved new restrictions on short sales that aim to improve investor confidence in the markets.
Rule 201, also known as the alternative uptick rule, will impose restrictions on short sales once a stock triggers the "circuit breaker," a 10% drop in a single day. The uptick rule will apply to short sale orders in that security for the rest of the day, as well as the following day.
"The rule is designed to preserve investor confidence and promote market efficiency, recognizing short selling can potentially have both a beneficial and a harmful impact on the market," said SEC Chairman Mary Schapiro. "It is important for the Commission and the markets to have in place a measure that creates certainty about how trading restrictions will operate during periods of stress and volatility."
The SEC received more than 4,300 comments on the proposal, with approximately two-thirds in favor of reinstating an uptick rule and a third against.
The rule was immediately criticized for being unnecessary and insufficient by Republican Commissioners Kathleen Casey and Troy Paredes, who voted against it.
"This is regulation by placebo," Casey said. "We are hopeful that the pill we've just had the patient take, although lacking potency, will convince him that everything is all right. There is no data or evidence offered to support the view that price declines, brought on by any type of selling, long or short, is a problem that can be cured by prohibiting short selling below the national best bid in particular stocks that have suffered intraday declines, or that investor confidence will be shored up by such a rule."
The practice of short selling allows investors to sell a security they do not own, usually by borrowing it from a brokerage firm, with the expectation that the stock will fall in value in a short time. They then buy the stock at a lower price than they borrowed it for, generating a profit.
"Short selling can facilitate buying by allowing investors going long to hedge their positions and can encourage market participation by leading to improved price discovery," Paredes said. "Because it is essential to the dynamics of price discovery and market efficiency, short selling ultimately bolsters investor confidence."
He said short selling helps prices reflect optimistic and pessimistic market perspectives.
"If contrarian views are not fully incorporated into prices, investors are unable to rely on market prices as reflecting the overall assessment of the market as to what a company is worth," Paredes said.
In 1938, the SEC enacted former Rule 10a-1, commonly known as the "uptick rule." That rule prohibited investors from short selling an exchange-listed security unless the sale price of the security had previously ticked upward. This rule remained virtually unchanged for nearly 70 years.
In 2004, the SEC authorized a study assessing the functionality and necessity of price test restrictions. Following a year-long pilot study, the Commission ultimately eliminated all short sale price test restrictions in 2007.
Big, Bad Short Sellers
Perhaps it was bad timing, but beginning in 2007, global markets experienced previously unseen levels of volatility. Wild swings in stock prices were attributed to short sellers and hedge funds, and industry leaders like Morgan Stanley's John Mack blamed the rampant shorting of financial shares for adding to 2008's financial panic.
The SEC instigated a number of temporary bans on short selling, such as the ban on "naked" short selling, or shorting a stock before actually borrowing it, but did not reinstate Rule 10a-1. The SEC's new Rule 201 does not reinstate 10a-1, either, but would be triggered in rare cases, such as on Oct. 10, 2008, when 68% of stocks fell more than 10%.
Any time a disaster follows a change in policy, people immediately suspect the change as the cause. Consider the following:
Drivers complain that the traffic flow on a busy stretch of highway is slow and inefficient. After a lengthy study, authorities decide to raise the speed limit. Soon after, there is a terrible, multiple-vehicle crash. Investigators can't prove for sure that the higher speed limit caused the crash, and note that there were crashes on the highway before the speed limit was raised. After a public outcry, authorities decide to lower the speed limit back to the previous level in order to make some drivers feel safer, but they know it won't guarantee safer roads in the future.
"If every short sale were harmful, or every short sale benign, our task would be straightforward," said Commissioner Luis Aguilar. "I believe that the rule before us today strikes a workable balance."
"Investor fears are extremely hard to quantify," said Henry Hu, director of the SEC's newly established Division of Risk, Strategy and Financial Innovation, adding that the data supporting both arguments for and against the new rule are uncertain. "There isn't enough data to allow quantification, and a judgment call must be involved."
Paredes, a former law professor, said the main rationale behind the rule, that restrictions on short sales will bolster investor confidence, is speculative and rooted in conjecture.
"Investor confidence is about investor psychology; and human psychology is notoriously difficult to predict and is not uniform across market actors," Paredes said. "The definition of investor confidence is deficient in that it omits any meaningful consideration of the link between market quality and the willingness of investors to participate actively in securities markets."
He said he is concerned that the Commission's main regulatory justification of investor confidence "affords the Commission too much discretion to regulate, unchecked by the discipline of more exacting and rigorous analysis."
"I predict that today's rule will be criticized as insufficient," Casey said. "What's more, as soon as our equity markets experience real volatility again, which they will at some point, the Commission will be criticized for not having taken more aggressive action, including full reinstatement of the old Rule 10a-1, which they will argue would have prevented such volatility."
The new rule is effective in 60 days. Market participants will have six months after that to comply.
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