An Evaluation of the SEC’s Prohibition on Naked Short Selling

So what exactly was the impact of the SEC’s July 15 emergency order against naked short selling? Not much, shows a study by Arturo Bris, a professor at Lausanne’s IMD business school. He shows that by some measures, it even had a detrimental effect on the market of the very stocks that the SEC sought to protect. For those who missed it, the list was:

Allianz Aktiengesellschaft (AZ), Bank Of America Corp (BAC), Barclays PLC (BCS), BNP Paribas (BNPQY.PK), Citigroup Inc (C), Credit Suisse Group (CS), Daiwa Securities Group Inc (DSECY), Deutsche Bank Group AG (DB), Fannie Mae (FNM), Freddie Mac (FRE), Goldman Sachs Group Inc (GS), HSBC Holdings plc (HBC), JPMorgan Chase & Co. (JPM), Lehman Bros Holdings Inc (LEH), Merrill Lynch & Co Inc (MER), Mizuho Financial Gp Adr (MFG), Morgan Stanley (MS), Royal Bank of Scotland Group plc (RBS), UBS AG (UBS).

The SEC ordered that before anyone could execute a short sale in any of 19 stocks on its list, the hopeful short seller had to locate shares that could be borrowed. For most investors, this was just a reiteration of regulation SHO. We heard from one brokerage firm that went well beyond the scope of the order and banned all short sales in the stocks on the list.

Bris’ study shows that as is often the case when the government gets involved in the markets, the law of unintended consequences took over. Market quality declined in the 19 stocks, which Bris shows through a number of metrics:

• Daily price volatility decreased after July 15. Bris calculated several measures: intraday (open-to-close) volatility, interday (close-to-close) volatility, trade price (high-low) range and positive and negative semi-variances.
• Bid-offer spreads have increased more than for other financial firms, and much more than for non-financial stocks. This means that liquidity deteriorated.
• Co-movements between the stocks on the list and the overall market increased. In an efficient market, individual stocks should be affected only by company-specific news rather than overall market activity.
• Short selling did not play a role in the deterioration of market quality.

Another finding of the study will give the SEC some food for thought about future restrictions on short selling:

• The performance of the stocks on the list has been worse than that of comparable firms, but not because of short selling. Weekly short selling activity has little effect on weekly returns. “After controlling for short sales, the performance of [these] stocks is still worse than for comparable firms.” The group underperformed its peers by 10 percent.
• Shorting activity before the SEC emergency order was highest for firms that were issuing convertible bonds. The implication is that much shorting is done by convertible bond arbitrage funds rather than vicious short sellers who try to destroy companies.

In short (no pun intended), the usefulness of the SEC’s emergency order is highly questionable. The SEC should concentrate on implementing the existing provisions of regulation SHO rather than dreaming up ever new rules.

Besides, we never quite understood why almost half of banks included on the list have their main trading venue outside SEC jurisdiction. Last time we checked, trading volume for UBS, Daiwa, BNP Paribas or Deutsche Bank was infinitely higher in Zurich, Tokyo, Paris or Frankfurt than in the U.S. It looks like regulators wanted to give the appearance of not favoring Wall Street houses by including some stocks for which its order is completely pointless.

Let’s wait and see what the SEC comes up with next. The climate is not favorable for shorting, and in an election year, someone has to take the blame for poor market performance. At least, it’s safe to assume that SEC rules will not be as ridiculous as a recent proposal in South Dakota to ban short selling altogether. And while we’re at it, here’s our tip for overzealous regulators: the housing market won’t recover if you ban short selling of real estate …

Comments

[Johnc222:]

The Author of this Article needs to do more research into the damaging effects of Naked short seliing. Naked short selling is Illegal and has destroyed over 7000 publicy traded companies.

You can not just continue to short a company stock in some cases 2x the Outstanding shares of the company, that drives companies into Chapt.11 by denying company the ability to raise capital in the open market.

Naked short selling is a criminal practice most done by off shore Hedge Funds. It's a crime, if you can not deliver the real certs in a 3 day time frame. The DTCC needs to be investigated there is a huge conflict of interest.

2008 Aug 15 08:12 AM

[john s. gordon:]

naked short selling is criminal & destructive,
> jack

2008 Aug 15 08:25 AM

[atavist.avatar:]

Faults and shortcomings in the manipulation and selection of the data used to support negative conclusions about the SEC ban on naked shortselling abound. These assessments are by an large either rubbish or self-serving.

2008 Aug 15 09:22 AM

[chtrplyr:]

I think the ban on naked short selling was extremely positive and much needed

2008 Aug 15 10:00 AM

[Thomas Kirc...:]

Let me clarify that I am not supporting naked short selling at all.
I am saying in my post that the SEC should implementing Reg SHO, which already bans naked shorting, and that there is no need for duplicate regulation.
The Deal Sleuth

2008 Aug 15 10:35 AM

[jjason:]

The inept management of the SEC in not doing anything about naked short selling is part of the problem. You probably know about the threshhold list and the fail to deliver statistics.

I would like to see naked short sellers prosecuted for this unlawful practice.

2008 Aug 15 02:49 PM

[trendsrus:]

Maybe actually reading the information contained in the study by Arturo Bris would help? The study claims that the stocks in question did worse than others and they did. The caveat that all seem to overlook is that the period the study covers is the first half of the year. Well of course the stocks in question performed worse in the period PRIOR to the emergency order --that is why they were put on protection from the naked short onslaught...

2008 Aug 15 07:29 PM

[tuskagee:]

The 'Short and Distort' artists we see destroying the market and companies today are basically supported by organized crime. Buying a quantity of puts beyond which are needed to protect long positions actually held should be prohibited. Naked shorting should have NEVER been allowed, even for market makers and their ilk. Offshore hedge funds seem to think they can operate with impunity from the balmy blue of the Carribean. Local sleezemeisters think they can do so due to SEC oblivion. In the process of shorting, naked or otherwise, the legitimate dreams of many law abiding investors have gone down the toilet. There was a time when investors had faith in companies and trusted that companies would do well over time, despite market perturbations. This healthy confidence has been usurped by liars, cheats, and thieving rumor-mongers who shout 'Fire' in a crowded theatre. The SEC simply must stop this and also reinstitute the uptick rule so normal investors have at least some scintilla of a chance.

2008 Aug 17 09:45 AM

[tuskagee:]

To put it shortly, it takes a long time to grow a tree and only a few minutes to chop it down....

2008 Aug 17 09:49 AM