In the depths of the financial crisis a year ago, short sellers were blamed for driving some of the world’s biggest financial institutions to the brink of ruin. Regulators around the globe responded with emergency bans on selling those stocks short.
Those bans have nearly all disappeared. It isn’t much harder now to bet against companies than it was before the crisis. The prohibitions didn’t stop stocks from tumbling and some say hampered trading.
The legacy of the crisis may turn out to be rules that address longstanding controversies with short selling and attempt to prevent selling frenzies like those that occurred last fall. Still, critics of short selling, including some in Congress, haven’t stopped their calls for tighter rules, even though there is little evidence these restrictions are effective.
Calling last year’s ban a ‘disaster’ for the smooth functioning of the stock market, Charles Jones, a finance professor at Columbia University, says the SEC has ‘moved toward a ‘sand in the gears’ approach of just slowing’ the short sellers, he says.
It is a similar story around the globe. In the United Kingdom, Australia, France and Germany, the focus is either on increased disclosure of short positions or prohibitions on ‘naked’ short selling — selling the stock without having the borrowed shares to deliver to the buyer, something already outlawed in the U.S. and the subject of stricter SEC regulations.
‘The real story is that a much more stringent rule set on borrowing [stocks] has been made,’ says Brian Fagen, a managing director in the equities division at Barclays Capital.
Last October, the SEC adopted a temporary rule — made permanent this summer — that bars a brokerage firm from shorting a stock for itself or another account if its client fails to deliver that stock within the time limits set by SEC rules.
At the time the rule was adopted last fall, such failures to deliver were rampant in the market, fueling criticism that short sellers were flouting the rules and ganging up on stocks to drive them down and make big profits. In the first nine months of 2008, the number of stocks with large numbers of shares that hadn’t been delivered to investors for an extended period never sank below 407 issues and rose as high as 702, according to Wall Street Journal research. Over the past six months, the number of stocks on the ‘threshold securities’ lists of major exchanges has dropped to an average of just 74 each day.
Daily figures for shares that aren’t delivered within the required three-day settlement period show a similar trend. In the 12 months through September 2008, 14 of every 100 shares traded weren’t delivered on time. Since then, the rate of delivery failures is down to an average of four shares per hundred.
Such a targeted approach is far from what happened a year ago. U.K. regulators acted first after the collapse of Lehman Brothers, banning new short selling of financial stocks on Sept. 18, 2008. The SEC followed quickly with its own ban on what would eventually total nearly 1,000 stocks — roughly one-fifth of listed U.S. stocks. The SEC ban lasted until Oct 8.
In the less than three weeks the ban was in place, the Dow Jones Industrial Average fell 16%.
Later, a study by the agency’s Office of Economic Analysis concluded that it was ‘long sellers’ — investors who had bought stocks thinking they would go up — who were selling the most during stock declines. Short sellers, the study said, became more active when stocks rose sharply.
Credit Suisse found the ban made stock pricing less efficient, which in turn can make buying or selling a stock more costly for investors. The firm’s data showed the difference between prices at which banned stocks could be bought and sold, the bid and asked prices, doubled during the ban. After the ban was lifted and short selling slowly resumed, spreads fell back to about 65% above preprohibition levels the third week of October.
Traders expect regulators outside the U.S. to take their cues from the SEC. But if the markets become volatile again, some say they would act on their own.
The SEC is still considering a significant change, involving a new version of the ‘uptick’ rule, which essentially allowed short sales only at a price higher than the previous trade — a rule deemed outdated and eliminated in 2007. During the crisis, the lack of an uptick rule was cited by many as enabling short sellers to drive stock prices lower.
Under consideration is a proposal barring short sellers from initiating a trade, on the theory that would make it harder to continuously sell a stock at lower and lower prices. Instead, the short sellers could only sell their borrowed shares when another investor places a buy order. Investors who already owned a stock and wanted to sell would face no restrictions on selling.
The SEC is seeking comments on its proposals, including whether new rules should be in place all the time or triggered when a stock posts a big decline, such as a 10% drop.
Dan Mathisson, a managing director at Credit Suisse, argues that the experience of last year’s ban shows that limiting short selling hampers the broader market. But if a rule is implemented it should be with a trigger, he says. ‘Without the circuit breakers it’s a bit ridiculous. Why slow down shorting on stocks that are shooting up?’
Columbia University’s Mr. Jones notes the vitriol aimed at short sellers has faded a year after the crisis. ‘When stock prices are tanking, people hate short-sellers,’ he says. ‘Right now stock prices have been rising, so you don’t hear as much about the ‘evil’ short sellers.’