Will All Short-Selling Be Banned Soon?

Short-selling comes under attack when markets tank. 2008 was no exception.

After the financial crisis hit big-time in late 2008, the government imposed a temporary ban on short-selling of certain stocks. The idea was that short-sellers might kill off certain businesses - mostly banks - that the government decided it wanted to save.

Now Germany has banned a specific kind of short-selling called "naked" short-selling - on certain kinds of securities and institutions. Their ban is similar to what the U.S. government did in 2008 in that it was a very selective move. In the U.S., the restrictions were lifted after a spell. The Germans said they will lift their restrictions in 2011.

But there are still those who want tighter restrictions on, if not the complete elimination of, short-selling. The odd thing is, short-selling had restrictions since the 1930's. And the government itself recently lifted those restrictions. Here's what happened.

I noticed this odd notice back in 2007. This appeared on the June 13, 2007 SEC website:

SEC Votes on Regulation SHO Amendments and Proposals;

Also Votes to Eliminate "Tick" Test

It didn't get much coverage. Surprising, since the "Tick" rule had been on the books since 1938, which makes it over 70 years old.

I called some professional colleagues. No one had seen this. They were puzzled too.

What is the "Tick" rule and why was it created in the first place?

The purpose of the rule was to prevent short-sellers of stock from piling onto a stock in a downtrend and quickly driving it down even further. Speculative traders like the legendary Jesse Livermore made fortunes before the Tick rule. They jumped on the back of a slumping stock and smashed it into the ground. Shareholders wept, and Livermore drank champagne.

Since the markets were still reeling from the 1929 crash and the country was suffering through the worst Depression in its history, the SEC (which was created after the disastrous Crash of 1929) sought ways to prevent, or at least control to some degree, obvious and vicious manipulation of the stock market. The goal was to inspire confidence in the markets - a confidence badly shaken after the Crash.

The Tick rule basically says that you can't short a stock on the way down until it's price has ticked up. It controls the number of shorts and slows the downward momentum that shorts can create. So why did the SEC rescind its 70 year old rule? It was part of an effort to, in their own words, "better safeguard investors and protect the integrity of the markets during short selling transactions by closing loopholes...."

But wasn't the rule originally installed to protect investors? What's changed between now and 1938? Well, the SEC says it ran a test in 2004 for a year and they concluded that rules like Rule 10-a (the tick rule) are no longer needed "because they modestly reduce liquidity and do not appear necessary to prevent manipulation. "

Two points: 1) What has changed since 1938 that will prevent short-sellers from jolting individual stocks and potentially markets, as they once did in the heyday of the Jesse Livermore types? 2) The test was conducted in a generally low volatility, rising stock market.

I can't imagine anything holding back short-sellers now that didn't hold them back then - without the tick rule. And, in fact, short-sellers did drive down the share prices of some firms during the 2007-2008 crisis time.

Also, while volatility was pretty low this year, until the last few weeks, during 2007-2008 it really picked up. And that's when the tick rule was supposed to help. So getting rid of it in times of low volatility made no sense at all.

Shortly after the rule was rescinded, the stock market experienced a 500+ point jolt to the downside in the stock market. Any connection?

Short-selling plays an important role in pricing in markets. I don't think it should be banned. But the government itself created the circumstances that allowed certain short-sellers to "pile on." So now they're talking about banning short-selling?

Sometimes it really seems like nothing the government does really makes much sense, doesn't it? The idea that short-selling be banned sounds ridiculous, but when you look at the track record of Federal regulation in this area, you've got to wonder whether this idea will pick up steam.

Comments

Popular Posts