Why the SEC Just Doesn't Get Short Sellers 14 comments
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Originally Monday’s essay was going to counter the most common inflationists’ arguments. However, over the weekend the SEC announced it is considering reinstating rules that make it more difficult to go short in the market. This move warrants immediate attention for a number of reasons, namely:
- It shows how much the SEC is on the side of Wall Street
- It’s another move that fixes nothing but looks good on paper
- It further sets us up for a full-blown repeat of 2008’s collapse.
Regarding the first point, the SEC first instated these rules temporarily back in July 2008. At that time, the story presented to the public was that “evil” short sellers are the guys responsible for taking down the market, resulting in Americans losing trillions of dollars.
Of course, as everyone knows, Wall Street banks collapsed due to greed, lack of oversight, excessive leverage, bad business practices, outright corruption, and fraud. However, these facts didn’t stop the SEC from vilifying investors who actually did the analysis to discover that the Wall Street firms were insolvent and went short as a result.
What I find so strange is that the SEC blamed short-sellers for allegedly taking Wall Street down… but didn’t investigate Wall Street analysts how continuously listed themselves and their competitors as “buys” all the way down to $0. Apparently bullishness that stems from corruption (or brazen stupidity) is OK. But fundamental analysis based on financial realities is considered “evil” or lacking in integrity.
Indeed, once the “anti-short” rules lapsed in August, the SEC was urged to take up more “anti-short” policies by none other than mega-Wall Street legal firm, Wachtell, Lipton, Rosen, & Katz. On this count, it’s worth noting that one of the lawyers who wrote the letter personally oversaw numerous Wall Street mergers (JP Morgan & Bear Stearns, Bank of America & Merrill Lynch, Wells Fargo & Wachovia). Obviously he’s an objective source and only interested in protecting the public from “evil” short selling activity (You can read the actual letter with highlighted passages here).
On a final note, anyone believing the SEC’s “anti-short” policies are aimed at protecting the public should note that the SEC just celebrated its 75th anniversary with an expensive dinner funded (in part) by Fidelity, Standard & Poor’s, D.E. Shaw & Co. (the hedge fund that paid Obama’s economic advisor Larry Summers $5 million) and other firms that the SEC is meant to regulate.
Aside from the various conflicts of interest, banning short selling or making it more difficult does NOTHING to help the financial system. It doesn’t clean up banks’ balance sheets, it doesn’t end market manipulation, it doesn’t clear crummy debt, it doesn’t stop insider trading… in fact it really doesn’t do much of anything except prop up financial stocks temporarily.
Here’s a chart of the Financials ETF from May 2008 to the end of last year. The SEC implemented its “anti-short” rules in July. Suffice to say, these rules didn’t do much in terms of preventing the inevitable.
Markets can be propped up and manipulated for a time… but ultimately they follow what fundamentals dictate. If financial firms own trillions in crummy debt and are effectively insolvent, it doesn’t matter if a government body makes it illegal to short sell them… they will eventually collapse regardless.
Indeed, one could quite easily argue that banning short-selling actually intensifies financial collapses rather than averting them. To go short, you have to borrow shares from a brokerage firm. Once the stock you’re shorting collapses you then have to buy the shares on the market in order to return them to the brokerage firm.
This is called “covering your shorts.” It’s not difficult to see how this can actually help stop a collapse. After all, at some point stocks will have fallen far enough that the shorts will want to take their profits. When they do this, they have to buy stocks… which brings the collapse to a halt and can actually kick off a rally (as it did for the rallies in November 2008 & March 2009).
By taking out short-sellers you’re removing a group of investors who HAVE to buy stocks once they collapse, leaving only those who are crazy enough to step in and buy during a full-blown collapse.
In conclusion, the SEC’s decision to potentially ban short selling again protects Wall Street, not individual investors. It also accomplishes nothing in the way of helping the financial system… and may in fact only make the eventual collapse even worse.
I already thought the market was due for a collapse in the coming weeks. However, if the SEC does implement these rules, we’ll probably see a short rally followed by a full-blown Crash again.
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This article has 14 comments:
Banning shorts. Is this going to be for retail investors only or is Goldman Sachs going to be allowed to buy derivatives that are effectively betting against the market?
I believe that large-scale, semi-coordinated short-attacks on financial stocks are a bad thing. But I think the uptick rule is overkill--it's too crude a tool. "Bad" short selling could be discouraged with more selective, nuanced regulations that wouldn't impact harmless short selling, which is 90% of it. Here are a few possibilities. (They could be combined with one another in various subtle ways.) The fact that market-makers (specialists) now handle trading in a computerized fashion makes it possible for these complicated rules to be applied automatically and accurately.
1. The uptick rule kicks in only after a stock has declined by some percentage that day and/or week.
2. The uptick rule kicks in only if the short interest in a stock is above a certain percentage, or if that interest has risen by more than a certain percentage in the past month.
3. The uptick rule kicks in more readily on financial stocks, because they are vulnerable to "runs on the bank" if massive short selling and rumor-mongering drives down their stock or bond price.
4. The uptick rule kicks in more easily on days the market has dropped substantially.
5. The uptick rule self-adjusts the uptick amount required, depending on considerations like those listed above. E.g., a stock might have to uptick only a penny in one situation, or a dime or a quarter in another. (In the situation where large upticks are required, they could accumulate over several smaller intermediate upticks.)
6. Small downticks (a penny or two, for instance) could count as "upticks" within the meaning of the act, in borderline situations. This would ensure that short selling would account for only moderate selling pressure.
7. Software could analyze short-selling volume to prevent short sellers from gaming the system by submitting a sequence of small transactions.
8. If one of the circuit breakers mentioned above tripped, it might merely (or as a first step) prohibit short-selling on margin, which would discourage short "raiding," which is the main problem.
9. Tax down-ticked short sales a bit.
Etc.
2. Because the penalties for "failing to deliver" on ANY equity sale, short sale or long sale, are so ridiculously cheap, too many players were intentionally selling without covering the borrow -- yeah, the naked people. Here is another place where equity markets could learn a thing or two from fixed income markets.
3. I agree the uptick rule will have very limited value in maintaining orderly markets, and probably force a lot of unproductive expense on the industry. But, it's simple and it utilizes rules that are already in "street memory." -- these systems and controls are not really new.
4. It would be better to simply force T+3 or T+4 buy-ins. That means if ANY seller doesn't deliver what he promised on settlement date, it gets purchased at the market and the seller eats the difference. THEN the economics control the short seller's actions, not the market mechanics. Ticks? Whatever. Pre-borrows? Whatever. Give symetry to buying and selling mechanics without friction, then put economic penalites downstream to control "bad behavior."
5. "He who sells what isn't his'n - makes delivery or goes to pris'n."
--rq
That's why the SEC likes to "shoot the messenger" in the form of short sellers. That's why it persecutes people like Bill Ackman and David Einhorn, while not investigating Bernie Madoff.
The moral of the story is that the SEC is more likely to allow you to run a "quiet" scam like Bernie Madoff than to tell the truth "noisily" like Ackman and Einhorn.
On Jul 06 08:43 AM reluctantQuant wrote:
> 1. I don't think anyone, including the SEC, is talking about "banning"
> short sellling. Anyone on that tirade needs to do some more homework.
>
>
> 2. Because the penalties for "failing to deliver" on ANY equity sale,
> short sale or long sale, are so ridiculously cheap, too many players
> were intentionally selling without covering the borrow -- yeah, the
> naked people. Here is another place where equity markets could learn
> a thing or two from fixed income markets.
>
> 3. I agree the uptick rule will have very limited value in maintaining
> orderly markets, and probably force a lot of unproductive expense
> on the industry. But, it's simple and it utilizes rules that are
> already in "street memory." -- these systems and controls are not
> really new.
>
> 4. It would be better to simply force T+3 or T+4 buy-ins. That means
> if ANY seller doesn't deliver what he promised on settlement date,
> it gets purchased at the market and the seller eats the difference.
> THEN the economics control the short seller's actions, not the market
> mechanics. Ticks? Whatever. Pre-borrows? Whatever. Give symetry to
> buying and selling mechanics without friction, then put economic
> penalites downstream to control "bad behavior."
>
> 5. "He who sells what isn't his'n - makes delivery or goes to pris'n."
>
>
> --rq
I believe this is the complaint of the average investor.
It looks like the author is completely unaware of the naked short sale which the SEC is supposed to prevent, but doesn't.
You might also want to send this to Michael Holland, who has constantly whined on Bloomberg about the uptick rule being a major cause of the great decline. Listening to people like that, who should know better but are always biased to the long side, you'd think that if the uptick rule hadn't been abolished, the djia would still be around 14,000 and the S&P500 at 1500.
We demand simple, easy explanations (our public school educations truly don't allow for complex reasoning or the ability to reason through complex problems) and want to punish the "bad". Harkens back to the days of public hangings being the best family entertainment in town.
As the Federal Reserve and Treasury, not to mention the mega-international corporations and Congress, have absolutely no reason to look any further to assess blame than the "evil" short-sellers and speculators (remember when it was their fault gas doubled?) they will just continue to pick the scapegoats and the largely clueless public will lap it up.
My father who has never invested one dime in any market or investment, has been badmouthing the shorts & speculators since MSM started pointing fingers last year.
As a matter of fact, the above named powers that be have trillions of reasons to NOT uncover their own duplicity in the mess we are in.
Once this ban takes and the market continues its path down, wonder what the villain of choice will be next?
Speculators?
401k administrators?
Employers?
Hell, let's just blame the poor sap who lost his job, home, retirement and car, this whole mess was obviously orchestrated by him. [/sarcasm]