FOR much of this financial crisis, America’s Securities and Exchange Commission (SEC) has cut a pathetic figure, relegated to the sidelines as a hyperactive Federal Reserve tried a variety of creative measures to keep the system afloat. When the market watchdog finally did get in on the act, it was highly controversial: a temporary order restricting short-selling the shares of 19 financial firms deemed systemically important, including Fannie Mae and Freddie Mac, the two troubled mortgage agencies.
The ban on “naked” short-selling—the sale of shares one has not yet borrowed—was announced on July 15th and allowed to lapse on August 12th. Its stated aim was to aid “price discovery”, but many suspected it was a share-support operation. This week saw feverish analysis of what, exactly, it had achieved, and what role, if any, abusive short-selling and other forms of manipulation may have played in exacerbating banks’ woes.
As regards the ban’s efficacy, arguments can be mustered on both sides, and no clear verdict has emerged. The value of the companies on the list rose sharply while it was in place, but the entire market was rallying. Short-sellers do not seem to have been deterred: for the nine American stocks on the list, short positions fell only slightly. And bid-ask spreads on the 19 stocks widened, suggesting the ban damaged market efficiency.
Some wonder why these firms were offered special protection in the first place, given that short-selling accounted for 12% of their outstanding shares in the months leading up to the ban, slightly less than the proportion for all financial firms.
The SEC has promised a post-mortem. But its mind seems made up. It is working on proposals to extend the naked-shorting ban to all shares. This could be in the rulebook within two months. There is talk of other changes, too, such as bringing back the “uptick” rule, which required traders to wait for a firm’s share price to rise before selling it short. This was designed to stop the relentless hammering of beaten-up stocks but was repealed in 2007 after studies suggested the decimalisation of market prices had rendered the rule ineffective. Another possibility is to introduce some sort of “circuit breaker”, which would put a brake on shorting if prices fell beyond a certain level. Some officials favour forcing traders to disclose large short positions.
Two questions hang over these efforts. First, does the SEC really need new rules to curb naked shorting? Under Regulation SHO, introduced in 2005, it has powers to tackle abusers, but it has used them timidly. The Government Accountability Office is probing the rule’s implementation.
One problem is the nebulousness of some wording. For instance, when locating stock to borrow, short-sellers need only have “reasonable grounds” to believe it can get hold of the shares. It is quite common for several hedge funds to execute a trade, each assuming it has access to, say, the 1m shares in Citigroup that Morgan Stanley has announced it has available to lend that day. This can lead to persistent “fails-to-deliver” (FTDs), which occur when the short-seller is unable to produce shares at settlement. These become “phantom” shares that can trade in the market as if they were real.
The second question is whether naked shorting really is such a problem for large financial firms. Of the 19 protected stocks, only Deutsche Bank was on the SEC’s “threshold” list for companies with a big FTD problem in the run-up to the July ban. This suggests the SEC’s focus on naked shorting is something of a red herring.
For the market as a whole, however, it appears to be a large and growing problem. Hundreds of smaller firms claim to have fallen victim to naked short-sellers (though some clearly only say that to excuse underperformance). Those worried about short-selling point out that options market-makers are exempt from naked-shorting restrictions: they can sell shares they have not located or borrowed if the aim is to keep markets liquid. But they can also, in effect, rent out this privilege to clients using derivatives contracts, under “market access” agreements. Hedge funds can, in theory, use these deals to launch bear raids in disguise.
It is impossible to know how big this problem is, but regulators accept it exists. The American Stock Exchange fined two market-makers for precisely this violation in July 2007. A month later the SEC proposed limiting or eliminating the exemption, but momentum stalled in the face of opposition from banks and exchanges.
The anti-short lobby, emboldened by the July ban, is again pushing for an end to the market-makers’ exemption. It has even grander ambitions. A group called American Entrepreneurs for Securities Reform has launched a ballot initiative in South Dakota that, if passed in November, would ban all naked shorting in the state, and force all brokers registered there to comply across the United States.
Opponents worry that the language is vague enough to outlaw all short-selling, though the initiative’s backers deny this is their intention. They have threatened action in a further 18 states if the SEC ban is not permanently extended to all shares this year.
How much does all this matter? Deliberate naked shorting has no place in a well-run market. But its effect on the big financial firms that keep regulators awake at night has been limited.
In any case, short-selling is not the only way to make money from a falling share price. As Bear Stearns began to reel in March, one canny (or bent) trader made a mint betting that the investment bank’s share price would halve within days, Bloomberg reported this week. The weapon used was not shorting, legitimate or naked, but put options, which give the buyer the right to offload shares at a fixed price in the future.
1 comment:
Searching for the naked truth
Aug 17th 2008
Economist
The real problem with abusive short-selling
FOR much of this financial crisis, America’s Securities and Exchange Commission (SEC) has cut a pathetic figure, relegated to the sidelines as a hyperactive Federal Reserve tried a variety of creative measures to keep the system afloat. When the market watchdog finally did get in on the act, it was highly controversial: a temporary order restricting short-selling the shares of 19 financial firms deemed systemically important, including Fannie Mae and Freddie Mac, the two troubled mortgage agencies.
The ban on “naked” short-selling—the sale of shares one has not yet borrowed—was announced on July 15th and allowed to lapse on August 12th. Its stated aim was to aid “price discovery”, but many suspected it was a share-support operation. This week saw feverish analysis of what, exactly, it had achieved, and what role, if any, abusive short-selling and other forms of manipulation may have played in exacerbating banks’ woes.
As regards the ban’s efficacy, arguments can be mustered on both sides, and no clear verdict has emerged. The value of the companies on the list rose sharply while it was in place, but the entire market was rallying. Short-sellers do not seem to have been deterred: for the nine American stocks on the list, short positions fell only slightly. And bid-ask spreads on the 19 stocks widened, suggesting the ban damaged market efficiency.
Some wonder why these firms were offered special protection in the first place, given that short-selling accounted for 12% of their outstanding shares in the months leading up to the ban, slightly less than the proportion for all financial firms.
The SEC has promised a post-mortem. But its mind seems made up. It is working on proposals to extend the naked-shorting ban to all shares. This could be in the rulebook within two months. There is talk of other changes, too, such as bringing back the “uptick” rule, which required traders to wait for a firm’s share price to rise before selling it short. This was designed to stop the relentless hammering of beaten-up stocks but was repealed in 2007 after studies suggested the decimalisation of market prices had rendered the rule ineffective. Another possibility is to introduce some sort of “circuit breaker”, which would put a brake on shorting if prices fell beyond a certain level. Some officials favour forcing traders to disclose large short positions.
Two questions hang over these efforts. First, does the SEC really need new rules to curb naked shorting? Under Regulation SHO, introduced in 2005, it has powers to tackle abusers, but it has used them timidly. The Government Accountability Office is probing the rule’s implementation.
One problem is the nebulousness of some wording. For instance, when locating stock to borrow, short-sellers need only have “reasonable grounds” to believe it can get hold of the shares. It is quite common for several hedge funds to execute a trade, each assuming it has access to, say, the 1m shares in Citigroup that Morgan Stanley has announced it has available to lend that day. This can lead to persistent “fails-to-deliver” (FTDs), which occur when the short-seller is unable to produce shares at settlement. These become “phantom” shares that can trade in the market as if they were real.
The second question is whether naked shorting really is such a problem for large financial firms. Of the 19 protected stocks, only Deutsche Bank was on the SEC’s “threshold” list for companies with a big FTD problem in the run-up to the July ban. This suggests the SEC’s focus on naked shorting is something of a red herring.
For the market as a whole, however, it appears to be a large and growing problem. Hundreds of smaller firms claim to have fallen victim to naked short-sellers (though some clearly only say that to excuse underperformance). Those worried about short-selling point out that options market-makers are exempt from naked-shorting restrictions: they can sell shares they have not located or borrowed if the aim is to keep markets liquid. But they can also, in effect, rent out this privilege to clients using derivatives contracts, under “market access” agreements. Hedge funds can, in theory, use these deals to launch bear raids in disguise.
It is impossible to know how big this problem is, but regulators accept it exists. The American Stock Exchange fined two market-makers for precisely this violation in July 2007. A month later the SEC proposed limiting or eliminating the exemption, but momentum stalled in the face of opposition from banks and exchanges.
The anti-short lobby, emboldened by the July ban, is again pushing for an end to the market-makers’ exemption. It has even grander ambitions. A group called American Entrepreneurs for Securities Reform has launched a ballot initiative in South Dakota that, if passed in November, would ban all naked shorting in the state, and force all brokers registered there to comply across the United States.
Opponents worry that the language is vague enough to outlaw all short-selling, though the initiative’s backers deny this is their intention. They have threatened action in a further 18 states if the SEC ban is not permanently extended to all shares this year.
How much does all this matter? Deliberate naked shorting has no place in a well-run market. But its effect on the big financial firms that keep regulators awake at night has been limited.
In any case, short-selling is not the only way to make money from a falling share price. As Bear Stearns began to reel in March, one canny (or bent) trader made a mint betting that the investment bank’s share price would halve within days, Bloomberg reported this week. The weapon used was not shorting, legitimate or naked, but put options, which give the buyer the right to offload shares at a fixed price in the future.
Post a Comment