Until now, one (but only one) of the stunning facts of financial markets in the US is that while funds have to make public their long positions (here is a good site), no such obligation existed for shorts positions. That’s about to change..

The SEC is considering an emergency rule to force funds to publicize their short positions (see article below). Together with the new rules effective tomorrow, this could be fun. All those new rules will put the shorts on the defensive, and offers a nice trading strategy.

Just take the reg SHO list (which list securities with failure to deliver problems, short trades for which no securities have been delivered), and start from the top. The defenses of the shorts were such that this strategy could backfire, as they nakedly shorted a whole lot more, especially in relatively small companies like InterOil.

But this has been made a whole lot more difficult, and what’s even more interesting, the way out through the options market has also been closed.

With the market down 450 points, but InterOil up strongly on high volume, we think such a trading strategy is already taking shape.

You might want to realize that if you work your way from top to bottom on the reg SHO list, you’ll find InterOil on top spot. It’s the obvious candidate for a short squeeze, backed by very good fundamental news (turn around in the refinery, top two flowing wells in the southern hemisphere, 9M acres of scarce drilling prospects), and more good news likely (third party assessment, deals, etc.).

One limiting factor might be that the SEC might give the shorting funds a little leeway, as a strict and immediate implementation of these rules could very well lead to bankruptcies, which is what the financial system can do without at the moment.

But we have little doubt that over the coming weeks, these new rules will have a considerably favourable effect on InterOil’s stock price, something of that was already visible today.

Now the SEC article:

Statements of SEC Chairman Christopher Cox and Enforcement Division Director Linda Thomsen Regarding Immediate Commission Actions to Combat Market Manipulation

• FOR IMMEDIATE RELEASE 2008-209
• Washington, D.C., Sept. 17, 2008 — Securities and Exchange Commission Chairman Christopher Cox and SEC Enforcement Division Director Linda Chatman Thomsen issued the following statements today concerning ongoing and forthcoming Commission actions to investigate fraud and manipulation in the nation’s securities markets:
• “Millions of investors entrust their savings to our securities markets because they can be confident that our markets are orderly, liquid, efficient, and rational,” said Chairman Cox. “The turmoil in today’s markets, particularly in the financial sector, is challenging that assumption for ordinary Americans. Markets are the best tool a free society has to price and allocate assets across a complex economy, but as is well known from experience, sometimes the wisdom of crowds is supplanted by crowd behavior. We need well-functioning markets to help us draw the line between reasonable miscalculation and error or something worse involving the failure of due diligence, self-dealing, and conflicts of interest. It is thus vitally important that the market mechanism continue to inspire investor confidence.
• “In order to ensure that hidden manipulation, illegal naked short selling, or illegitimate trading tactics do not drive market behavior and undermine confidence, the SEC today took several actions to address short selling abuses,” Chairman Cox continued. “In addition to these initiatives, which will take effect at 12:01 a.m. ET on Thursday, I am asking the Commission to consider on an emergency basis a new disclosure rule that will require hedge funds and other large investors to disclose their short positions. Prepared by the staffs of the Division of Investment Management and the Division of Corporation Finance, the new rule will be designed to ensure transparency in short selling. Managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. The managers currently report their long positions to the SEC.”
• Chairman Cox continued, “Director Thomsen and the Division of Enforcement will also expand their ongoing investigations by undertaking a series of additional enforcement measures against market manipulation. The Enforcement Division will obtain disclosure from significant hedge funds and other institutional traders of their past trading positions in specific securities. Those institutions will also be required immediately to secure all of their communication records in anticipation of subpoenas for these records.”
• SEC Director of Enforcement Linda Chatman Thomsen said, “The Enforcement Division has been investigating and will continue to investigate any suggestion of manipulative trading. We are committed to using every weapon in our arsenal to combat market manipulation that threatens investors and capital markets.” The Commission is actively considering additional actions as appropriate.

Let’s hope that they will enforce these new rules a little better than the old, as even under the old rules, being 515 consecutive trading days on the reg. SHO list is not exactly an indicator of garden variety settlement problems.

That, in fact, is exactly what they announce, as they will obtain disclosure from significant hedge funds and other institutional traders of their past trading positions in specific securities.

This could become interesting…