The Naked Truth

By John Hintze

The Naked Truth:

SEC Emergency Orders Revamp Short Sales, More Changes Fretted

By John Hintze

Since the first emergency rule this summer to hinder naked short selling of securities, the Dow Jones Industrial Average has plummeted more than 500 points on multiple occasions, suggesting other factors were fueling the stock routs. Even so, the financial industry appears gingerly to support September's hard close rule aimed at curbing unbridled shorting, while another contingent, including a former SEC chairman, champions even stronger measures.

The SEC first banned short selling of 19 financial stocks in July, after their prices were pummeled. The ban was extended to 799 stocks on Sept. 18, and grew to more than 1,000 before it ended Oct. 8. Around the same time, the regulator issued two more emergency rules, one requiring investors managing more than $100 million in assets to disclose publicly short positions on a weekly basis. The other imposed a temporary version of Rule 204T, the hard close, requiring broker-dealers to have delivered securities shorted by the start of trading the day after a three-day settlement (referred to as T+4), of face problematic options.

Moving into the New Year, it remains murky how those bans have affected market volatility, although disrupting the status quo was clearly painful to some. In its comment on the 204T and disclosure interim rules, the Options Clearing Corp., the options industry's clearance and settlement house, said: “Even when an emergency action ends, its impact lingers.” Some participants may have been unaware of the order's expiration, it noted, and others, fearful of another sudden ban, may be reluctant to resume their previous activities.

Comments on proposals to make the hard close and disclosure rules permanent were due Dec. 16. Those proposals switched from temporary emergency actions to interim final temporary rules in mid-October and are set to expire by Aug. 1.

The SEC has become an easy punching bag, but there's no shortage of factors potentially fueling volatility. They now include mostly automated trading platforms and trading tools revving orders combined with the disappearance of floor traders to act as brakes, as top NYSE Euronext executives have suggested. Leveraged exchange traded funds may be perpetrators behind now-common post-3 p.m. selloffs. The SEC's elimination of the uptick rule in July 2007, in which a security can only be shorted above the price of the preceding sale, has also come under fire. That is compounded by investors' fear that the next shoe in the credit crisis will fall on them.

In any case, volatility and the SEC's response to it has changed the short-selling environment dramatically. For one, there's less of it. On July 15, NASDAQ's short-interest volume towered at nearly 11 billion shares and by Dec. 15, the most recent data available, it had plunged 35 percent to under 7.1 billion, all while investors grew more pessimistic and share prices fell.

In addition, broker-dealers have finally found a way to deliver securities on time. Regulation SHO, first effective in January 2005, established the concept of threshold securities, which the exchanges list when their deliveries become delinquent. Short sellers must borrow securities to cover their short sales, intending to buyback the securities at a lower price later and pocket the difference. Under Reg SHO, securities enter the threshold lists when fails to deliver exceed 0.5 percent of the issue's total shares outstanding. Mandatory closeout provisions then take place on all future fails that last more than 13 days.

Options market makers, which short stocks to hedge positions, were exempted from those requirements and could maintain open fails indefinitely in the act of bona-fide market making. That exemption was eliminated when the hard close went into place. Options-industry representatives successfully pleaded with SEC staff that weekend to extend options makers' delivery period to T+6, the same length of time required to deliver securities for long sales.

If broker-dealers fail to deliver securities on time under the interim rules, they are prohibited from further shorting the security until they close out the delivery failure at the current market price. Although closeouts can be rough and inefficient, and potentially costly if the stock price increases, the penalty could have been more severe, such as actual penalty fees. Nevertheless, NYSE's threshold list was around 100 in July and by December it fell to single digits, while NASDAQ's fell from about 300 to below 50 over the same period.

Whether the drop is due to broker-dealers fearing mandatory closeouts or heightened regulatory scrutiny, or both, will become clearer over time. Their concerns, however, have had the additional effect of raising borrowing costs. Lenders receive interest payments from reinvesting collateral minus any rebates they return to borrowers. For less liquid, harder to borrow securities, the rebate can turn negative, so that short sellers actually have to make daily payments to lenders instead of receiving them. “Our data shows that rebates for hard-to-borrow securities in the Russell 2000 declined to negative 8.2 percent in July from negative 5.03 percent,” said Josh Galper, managing principal at consultancy Finadium. Galper added that the benchmark federal funds rate also declined during that period, “But it was still a significant decline.”

Longstanding Industry Opposition Softens

The large broker-dealers and their representatives mostly opposed the July 2006 elimination of Reg SHO's grandfather exception, which allowed brokers to maintain open fails indefinitely until securities entered threshold status. The same held true for the market maker exception, which the SEC postponed eliminating until its emergency-order bombardment. However, comments on the interim rules, arguably far more intrusive, generally support the regulatory thrust.

The Securities Industry and Financial Markets Association, for example, recommends extending the close-out deadline to T+3 for all broker-dealers, and stretching the deadline to the market's close instead of its open softer, but still a hard close. The Options Clearing Corp. suggests a uniform T+5 extension, with the option to borrow securities that fail to deliver.

Some even recommend tightening the rules further. Since the hard close permits shorting without deliveries within T+4 timeframe, the American Bankers Association suggests that to truly eliminate delivery failures, the shorted securities should be pre-borrowed, with an exception for market makers. Pre-borrow critics say, however, that it would severely crimp short sellers except those who are customers of broker-dealers with massive securities inventories.

Former SEC Chairman Harvey Pitt said open fails may not be the only factor behind market volatility, but they're “clearly a big problem.” He said he supports the hard close but called it insufficient. “The entire issue can be resolved fairly easily if you say nobody can sell securities short unless they have a legally enforceable right to deliver those securities at the time of closing.”

Pitt heads up Kalorama Partners, which along with Jersey City-based Locatestock.com plans to launch by early February an electronic auction market for securities lending participants that will provide a paper trail and a contractual right for deliveries. Reg SHO, instead, requires a “reasonable belief” that shares can be delivered, and “as any lawyer will tell you, you can drive a truck through a reasonable basis to believe,” Pitt said.

New York's Quadriserv is building a similar central counterparty to accommodate securities lending transactions, and more established firms such as Equilend and Sungard's Loanet already provide systems to automated the front- and back-end processes of securities lending transactions. Trading platforms displaying bids and offers may bring additional transparency to a market that, despite its enormous size, has been conducted mostly on a bilateral basis.

More Solutions To Temper Abusive Shorting

The SEC's other interim final temporary rule, requiring public disclosure of short positions one a week on the new Form SH, also flustered short-selling proponents when it was first issued as a temporary emergency order. The rule only applies to filers of Form 13F, which discloses large institutions' long positions and number of shares once a quarter. The regulator later moderated it to require Form SHO to be filed only with the SEC. Nevertheless, the SEC is still considering whether those disclosures should be public—the interim rule proposal requests comment on the issue and, if public disclosures are warranted, asks how long after the relevant period.

Jamie Selway, founder and managing director of New York's White Cap Trading, which aims to employ expertise in electronic markets and market structure to provide effective executions for clients, said there's talk among market participants about symmetry between long and short disclosures. Issuers, however, are much fonder of long investors than short sellers, and there's concern institutions responsibly exercising bearish views may find access to company executives curtailed if their identities are revealed. As a result, Selway said, “There's fear that disclosure of shorts will make people less likely to short.”

Pitt said a balance between privacy and the public's right to know is necessary. He added that providing detailed disclosures first to the SEC “is critical.” He also said there should be public disclosure of generic information about short positions in specific securities. “It's not as important for an investor to know who is holding short positions as it is to know the volume of short positions outstanding on a specific stock,” Pitt said.

The SEC is also said to be considering reinstatement of the uptick rule, although it will likely have to take a different shape given that a penny difference in today's market is much less of a deterrent than an eighth of a dollar, before the decimalization of quotes in 2001. “I understand the argument that a penny up is meaningless. But you can also say look at the increase in volatility since the uptick rule was eliminated,” said Robert Ellis, senior analyst at Celent's wealth management group.

Jeffrey Rubin, director of research at Birinyi Associates, notes that the SEC's research backing up its decision to eliminate the uptick rule occurred during a period when the market was up 30 percent. “You don't need an uptick rule when there's a normal market; it was put in place for situations like the current one,” Rubin says.

Pitt says there are concerns about how effectively the uptick rule can be re-implemented and whether it can be manipulated by market participants. In addition, the original uptick rule prompted concerns because it was applied by the NYSE but not the NASDAQ, he says. “Those are some of the issues that would have to be addressed,” Pitt said.

Bigger Picture Reform Required?

The SEC's interim rules have already resulted in significant structural and behavioral changes to the short selling market, as would reinstating the uptick rule. Ellis says, however, that bigger market-structure fixes are necessary. Referring to a Wall Street Journal article March 26, Ellis noted the S&P 500 ending the previous trading day at 1,352.99, below the 1,362.80 it hit in April 1999, and when dividends and inflation were factored into returns the index rose a measly 1.3 percent on average annually over the prior 10 years. Mutual funds, he said, also performed poorly, and that was before the S&P 500 descending to 850 range.

Ellis attributes much of the poor performance to institutional investors, and especially mutual funds, increasingly lending out their securities to short sellers. Those mutual funds may generate an extra 10 basis points lending their securities and perhaps marginally outperform rivals, “but its not really passed along to investors because stocks that should have been moving up have instead been driven down by as they're lent to short sellers,” Ellis said.

That's particularly problematic for today's investors, who have increasingly taken responsibility for funding their retirements. “Americans with RIAs abnd 401Ks are sitting ducks,” Ellis said, adding that “a simple solution would be to create a class of shares, call it the R class, that can't be shorted.”

So while the current rule changes on the table may succeed in tying up loose ends and perhaps even eliminating certain shenanigans, they're unlikely to excite retail investors who have seen their retirement accounts deflating along with the stock indices. And those retirement accounts provide the steady, mass capital inflows that ultimately bolster the overall market. “I think what the institutional piece forgot is that if you kill the retail piece, you've killed the golden goose,” Ellis says.

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Posted on Jan. 23, 2009