Short Cox: Panic-Stricken Regulator Is Walking It Back

For a man who has spent much of the last four months impotently fulminating against so far unfound ‘early fact’-mongers, market manipulators and various other elusive and mostly imaginary specters, US Securities and Exchange Commission chairman Christopher Cox this week suddenly made himself relevant to the financial markets.

But probably the most direct market intervention since the agency’s founding in 1934, Tuesday’s emergency order banning ‘naked’ short-selling of the stock of Phoney (FNM) and Fraudy (FRE), and the 17 US-listed primary dealers (10 of them foreign companies), has generated considerable bewilderment even among apparently law-abiding market participants.

As well, the order has drawn attention to what may be a certain inattentiveness on the SEC’s part in enforcing its current short-selling regulations. And the announcement Thursday night that market makers would be exempt from the emergency order “to avoid constraining their provision of liquidity,” essentially castrates the initiative, while raising serious questions about how the agency maneuvered, or was maneuvered, into a dunce’s corner.

Under Reg SHO, the short-selling regime introduced on Jan. 3, 2005, broker-dealers were required only “to have reasonable grounds to believe” that a security could be borrowed and “delivered on the date delivery is due” before effecting a short sale order. “This ‘locate’ must be made and documented prior to effecting the short sale,” according to the SEC, although an exception is available for “market makers engaged in bona fide market making.”

As of 12:01 am EDT Monday, Jul. 21, stock in the affected securities must not only be ‘located’ but ‘pre-borrowed’ for a specific short sale. The order terminates on Tuesday, Jul. 29, at 11:59 pm although it can be extended by up to 30 days from Jul. 21.

Tunnza questions, not many answers

Thurday afternoon, NakedShorts lurked on a conference call hosted by an influential buy-side trade association, and heard confusion as to how the pre-borrow requirement will work. One speaker said that Lehman Bros’ (LEH) back office staff had told customers that they would be required to identify the source of the borrowed stock; the quantity; and the time that the borrow was confirmed or provide a confirmation number, before the order was accepted. Other brokers, the speaker said, may be doing things differently.

Also on the call:

• Complaints that SEC staff are not responding to questions about the emergency order. Callers are instead being referred to SROs (self-regulatory organizations), which offer little in the way of guidance.
• Uncertainty over whether the order applies to preferred securities issued by the named issuers (the order lists only the main trading symbol, and elsewhere seems to limit the order to “the securities identified...” so, on its face, knock yourself out. Your mileage may vary).
• Uncertainty over whether existing short positions will be ‘grandfathered.’ And
• A representative of Deutsche Asset Management asking whether the order would apply to SEC-registered investment advisors based offshore; trades made in US accounts located outside the US; or trades made on other markets (See: More holes, below). And,

Christmas for stock lenders

The emergency order has already benefited broker-dealers by at least contributing to the healthy rally in financial stocks since Cox announced the action, at about 12:30 pm EDT Tuesday during a Senate Banking Committee hearing. Lehman Bros, which has for months whined about its alleged victimization by an alleged “coordinated attack,” was trading at around $13.75 when Cox began speaking; it closed Thursday at $18.27, after topping $20 earlier in the day. The run from Tuesday’s low, at $12.02, to Thursday’s high, at $20.15, was a mere 68 per cent.

And while it won’t have as much impact on their stock prices, the pre-borrow requirement will goose brokers’ revenues by allowing them to bump securities lending rates. The SEC believes that the supply of stock available for lending had been artificially inflated by those very same brokers allowing multiple investors to access the same stock inventory for the purposes of meeting the ‘locate’ requirement. (It’s not clear whether that was a legitimate loophole, or a breach of Reg SHO; if the latter we’ll hear all about it when the triumphal press release release appears, possibly accompanied by the recently revived Giuliani-era perp walk.)

Finally, it’s not beyond the bounds of possibility that brokers will choose to favor their own prop desks and market makers in stock lending, telling customers - “I know. It’s a shame, but you know the SEC.”

Walk-back will minimize impact

The announcement Thursday night that the SEC staff was recommending an exemption from the emergency order for “market makers of the 19 stocks and their derivatives...to avoid constraining the market makers' provision of liquidity," means that the order will, in the end, have only minimal market impact.

Options markets makers and swaps dealers, who often have to short stock to hedge their own books, would have been seriously handicapped, and market liquidity would have been substantially affected, had the order been implemented as written. The second sentence of footnote 3 on the emergency order specifically stated that: “In addition, we note that short sales used to hedge would also be subject to this order.”

The walk-back means that the options and swaps markets should continue to function relatively efficiently, although now under a pall of regulatory uncertainty.

And if you absolutely, positively, have to get a short stock position on, you’re not a market maker and you can’t get a borrow?

Ten of the companies covered by the emergency order are headquartered outside the US. Those stocks tend to be significantly more liquid on their home bourses than in the US: France — BNP Paribas (BNPQY.PK); Germany — Allianz SE (AZ), Deutsche Bank (DB); Japan — Daiwa Securities (DSECY), Mizuho Financial Group (MFG); Switzerland — Credit Suisse (CS), UBS (UBS); and the United Kingdom — Barclays (BCS), Royal Bank of Scotland (RBS), HSBC (HBC).

As well, several of the US-based companies have foreign listings, most in Europe. While volume is infinitesimal, the securities are fungible, and the regulators tend to be big on both principles, and not watching too closely what‘s going on. It may well be possible, with a little help from your friends, to do something continental that might by Monday morning be severely frowned upon in Washington DC.

SEC to grant market makers leniency on short sales
by Svea Herbst-Bayliss and Rachelle Younglai
Reuters Jul. 18 2008

Emergency order background:

Emergency order...taking temporary action...
US Securities and Exchange Commission Release No. 58166
Jul. 15 2008

SEC Enhances Investor Protections Against Naked Short Selling
US Securities and Exchange press release Jul. 15 2008

Testimony concerning recent developments in US financial markets
Christopher Cox, chairman, SEC
US Senate Committee on Banking, Housing and Urban Affairs
Jul. 15 2008

SEC Issues Emergency Order Restricting Short Selling
Schulte Roth & Zabel LLC
Jul. 16 2008

Reg SHO Background:

Key Points About Regulation SHO
SEC Division of Market Regulation
Apr. 11 2008

The Daily Options Report Commentary:

Options trader Adam Warner was all over this story, emphasizing the issues that would arise if options markets makers and those similarly situated had been forced to implement the SEC emergency order as it was originally written.

Even More Shorting Thoughts
Jul. 17 2008

More Shorting
Jul. 17 2008

Short Scream
Jul. 17 2008

To the Mats
Jul. 16 2008

Bubblevision has it right
Jul. 15 2008

Rumors (related)
Jul. 15 2008

Comments

[MarionPolk:]

Are the SEC commissioners criminals or idiots? FRE has current open put contracts that could have allowed the sale of over 45 million shares "created" by the OMM exemption.

If in fact the SEC allows the OMM exemption to continue, then any other restrictions on naked short sales aren't worth the bandwidth used to publish them.

Unlimited share creation equals unlimited capital destruction. Granted no journalist could be expected to grasp this simple concept, but it could be hoped that SEC commissioners are more sophisticated than stenographers, who just transcribe and print the contents of phone calls they receive from hedge fund managers.

2008 Jul 18 08:59 AM

[jjason:]

I have read Greg Newton's comments and I wonder if he is for or against naked short selling? What's your opinion,Greg?

It seems that some firms like LEH, BS, MER, FNM, and FRE are now victims of short selling or naked short selling. The executives of these firms want something done about it. How many of these firms are guilty of naked short selling and are part of the problem?


However, ALL THE FIRMS ON THE THRESHOLD LIST THAT BESPOKE INVESTMENT GROUP PUBLISHED ON SEEKINGALPHA ON JULY 15,2008 are victims of short selling and NAKED SHORT SELLING.

So who is going to correct this injustice? Are there any readers who know what recourse investors have to recover from industry insiders who have been involved in the illegal activity of naked short selling?

I would appreciate hearing your answers to my questions.

2008 Jul 18 09:33 AM

[adan:]

the selectivity of previously unenforced naked shorting rules, while continuing to not address the many many stocks that have been on the naked short lists for so very long, is continuing to destroy many people's trust in a system where trust is the final invisible hand....

2008 Jul 19 08:48 AM

[adan:]

the selectivity of previously unenforced naked shorting rules, while continuing to not address the many many stocks that have been on the naked short lists for so very long, is continuing to destroy many people's trust in a system where trust is the final invisible hand....

2008 Jul 19 08:48 AM