New rules against abusive shorting in the make

A couple of articles on new rules against manipulative shorting that are in the works. The second article shows that the SEC, mulling over a reinstatement of some form of the uptick rule, still doesn’t quite get it..

Putting Some Clothes On Capital Markets
How to fix naked short-selling, by Brett Joshpe

With the stock market losing approximately half its value in 17 months, talk is rampant about how best to regulate businesses and capital markets to prevent future financial crises. To that end, Sens. Ted Kaufman, D-Del., and Johnny Isakson, R-Ga., introduced a bill this month that would accomplish two important goals: improving the efficient and transparent functioning of equity markets, and preventing the price manipulation that helped push our financial system to the brink.

It requires the Securities Exchange Commission (SEC) to revise several rules, including reinstating the uptick rule and tightening rules against naked short-selling. The uptick rule, which has been the focus of much discussion after it was repealed in 2007, banned short-selling unless the sale price was higher than the last different price.

The current proposal would go further than the prior rule by eliminating “zero plus” tick short sales, which is when the stock trades flat after a prior uptick. Short-sellers would only be able to sell on a legitimate increase and, in the case of financial stocks, only after a five cent or more increase.

Cracking down on naked short-selling, however, is even more crucial in preventing stock manipulations that would damage the market. Currently, the rule against naked short-selling requires short-sellers to do one of three things: borrow the stock prior to selling it short, identify the stock before selling it short, or have a reasonable belief that they will be able to locate the stock in the future. This third prong is the exception that swallows the rule.

What frequently happens is that market participants short a stock but later fail to deliver it. The rules currently give a buyer’s broker the option–but not mandate–to buy-in the short-seller’s undelivered shares–that is, purchase the undelivered shares in the market and charge the seller’s broker the cost of doing so.

However, brokers frequently have off-setting short sales on their books that remain unfilled. Rather than purchasing stock at the market price and actually delivering the shares, brokers can let each other’s unfilled deliveries ride as part of a gentleman’s agreement.

There are several implications to this practice. First, failing to deliver on short sales creates “phantom shares” and an artificially inflated supply of stock. Phantom shares are similar to counterfeit dollars that move through the system seamlessly until someone is caught holding a worthless bill. The artificial supply drives down the price of a company’s stock, and because stock values are artificially depressed and manipulated, businesses are less inclined to access the capital markets. As a result, companies forgo potential capital, which raises the cost of money, something that has exacerbated the recession.

Naked short-selling also intensifies bear raids by making it easier for traders to short stocks, since they do not actually borrow the shares in advance. And, in fact, SEC and Bloomberg data indicate the practice may have helped cause the Lehman Brothers collapse, as more than 37 million shares were sold short and not delivered as of Sept. 11, 2008, compared with more than 500,000 at the peak of 2007.

Similar practices also caused massive systemic exposure to credit default swaps (CDS), as traders bet on credit defaults without holding any of the underlying debt obligations. Although the practice was not prohibited, it created a massive market for gambling on companies’ credit worthiness without limiting those bets to the value of the underlying obligations.

Although the newly proposed rules would not address CDS trading practices, they would limit naked short-selling in several important ways. First, they would require short-sellers to demonstrate a legally enforceable right to deliver the shares on the required date. No longer could short-sellers rely on the exception that they only have a reasonable expectation of locating the shares. Second, whereas buyer’s brokers were permitted to purchase shares in the open market to cover the trade before, now they would be required to cover the sale and pass the costs to the seller’s broker.

The bill introduced by Kaufman and Isakson would also require short sales to settle on the same three-day time frame as long sales (commonly referred to as T+3), as opposed to 13 days. Jonathan Johnson, president of and an opponent of naked short-selling, says, “While the SEC has put in half-measures that merely curb manipulative naked short-selling, this bill proposes real solutions that will stop this market manipulation. It is long overdue.”

The temptation for lawmakers and regulators amid an economic crisis is to employ measures that overcompensate and over-regulate by appealing to populist angers, such as outrage over executive bonuses, rather than making finely considered tweaks. Requiring that short-sellers actually have the ability to deliver the shares they are legally obligated to deliver would do just that, putting some badly needed clothes on a still very cold market.


If this bill is introduced, it would be very good news. However, the SEC is still not quite up to the game, if the deliberations coming out of it are representative, see article here. Witness the following quote:

  • “There is some political pressure to get something done on the short sale rules so we’re trying to come up with something that would satisfy the political pressure, but also not be too onerous on the market participants,” the source said.