May 3, 2009
The following comment on the proposed uptick rule includes a porposal for an up-day restriction on short sales for consideration by the round table:
The Markets Need Viable Restrictions on Short Selling
As a small investor in the stock market, I am delighted that the SEC has undertaken this review of the need for reinstating an uptick rule. If nothing else, the last year in the stock markets has shown that regulation is needed to, as the SECs mission statement says, protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
The original rule provided me as an investor with an essential protection: the ability to sell my holding when bad news happened without worrying that others, with no investment risk in the stock, were quickly selling it short, thus driving the price and value of my holding down before I could sell it.
Since the rules inception in 1938, the effectiveness of that original protection has gradually eroded due to technology:
Implementation of electronic world-wide trading increased the rapidity of trades and thus price movements up and down, and
The change to penny increments in trading made an uptick a penny rather than 1/8 of a dollar, and such penny price moves up and down happen frequently, even when the overall price of a stock was falling.
In spite of this erosion, apparently the penny uptick rule was serving an important investor protection because since its removal we have seen the return of bear raids. Bear raids are when short sellers sell a large quantity of shares of a companys stock rapidly to drive the price of a stock down and create panic selling, so they can buy it back later at a lower price and profit from it. Such raids contributed to the failure of numerous financial firms in the past year and the crash of the markets.
Fair, Orderly, and Efficient Markets
Since removal of the uptick rule we have seen wild swings in the price of stocks, as both holders and short sellers of the stock react to news about a stock. Short sellers sell a stock quickly in order to profit from being first to hear bad news forcing holders of stock have to react to bad news quickly as well, because they know that short sellers will drive the price of their holding down. This begs a basic fairness question for investors: Investors have invested in stock and hold it – they have money on the table. Short sellers have no skin in the game until bad news breaks. Why should short sellers have an equal ability to sell the stock and profit? Under the original uptick rule, short sellers would have had to wait for the price of a stock to be going up in order to sell it short. First access to bad news was not sufficient for a short seller to profit. Indeed part of the value of allowing short selling in the market at all is that short sellers do research and discover new information that leads them to sell a stock short, not that they have first access to general news about a stock.
In 2008, there were a number of trading days when the markets saw some of the largest single day losses and gains in market history. The markets also saw the highest market volatility in history. Such wild price movements are not orderly and do not reassure investors in stocks to participate in the markets or hold their investments.
Facilitate Capital Formation
As you have pointed out in the proposed rule, short selling improves liquidity in the markets and assists in price discovery. It does not, however contribute to capital formation. Indeed, as the last year has shown, unfettered short selling can destroy capital and preclude capital formation. In 2008, about $6 trillion in market capital was lost. It is a rare firm now that goes to the markets to raise capital – I believe there were none in January of this year. This is partly due to panic resulting from seeing successive bear raids on large financial firms (which an uptick rule would have prevented).
This panic has morphed into lost confidence as long term investors realize they are no longer protected against short sellers. Many have left the markets, and will not return unless strong protection is put in place. I for one will not be investing in stock unless viable protection is put in place against short sellers.
Comments on the specific SEC proposals
Proposed modified uptick rule: While this proposal might be technically easier to implement, it is too complicated for average investors to understand. The original uptick rule was both simple to understand and appeared easy to enforce. New investor protection needs to be easily understood to reassure investors.
Proposed uptick rule: This would be better than nothing, but is not sufficient to protect investors. As the SECs own study showed, it was only marginally effective with penny trading. It could potentially be viable with a larger increment of trading, but apparently that would be complicated to implement.
Security-Specific circuit breaker halt rule: It will not restore much confidence in long term investors to know that only after shorts have driven the price of their shares down severely in a day, short selling will be suspended. Shorts can take some of your value, than we will stop them – for today? What about tomorrow? Can they do it all over again? And again?
Security –Specific circuit breaker modified uptick rule: Here again, investors will not be very re-assured by a rule that allows short sellers to severely drive down the price of their holding. In this case it is even worse, however, since we arent stopping shorting on their stock, only controlling further, future short selling.
Security-Specific circuit breaker uptick rule: See comment on the modified uptick rule.
The Up-Day Rule – A New Approach
The SEC should consider stronger protection for investors, consistent with its charter to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. One proposal the SEC should consider is an up-day rule in which short selling of a stock would only be allowed when the price of the stock is above its opening price of the session. Such a rule would be simple to implement, since the opening price is regularly available for every stock traded on the markets at any moment throughout the day. Furthermore, it is easy to understand both the rule and the protection it provides, so it would go a long way toward reassuring long term investors that they are protected against short selling. And it should not get in the way of short selling based on research rather than simply on the latest news, because such short sellers will have an opportunity to take short positions as prices rise. It would:
Protect investors, since short sellers would not be able to drive the price of their stock down during a trading day.
Maintain fair, orderly and efficient markets by setting a clear, easily understood rule that assures that those with money on the table have priority on bad news over those that do not. It also would be easily implemented.
Facilitate capital formation by assuring investors that they need not sell their holding due to fear that short sellers will drive the price down. Thus calming the markets, preventing panic selling and restoring confidence in investors which will facilitate capital formation.
Naked Short Selling
While not directly addressed in the rulemaking, a number of comments have blamed recent markets difficulties on so-called naked short selling, and say there is no need for an uptick protection, rather simply stop naked shorting. First, putting in place a strong uptick rule, such as the up-day proposal, will stop most naked shorting because it will take away the ability of short sellers to drive the price of a stock down rapidly, and so eliminate the incentive to short rapidly (before shares can be located to be borrowed).
There is no question that naked shorting should be stopped. However, simply stopping naked shorting is not sufficient to reassure investors. What concerns me as an investor is that short sellers (whether naked or not) can drive down the price of my investments.
Naked shorting is selling stock short that one has not borrowed. I am a layman, but as I understand financial transactions, selling something that one has no right to is a form of fraud. Hence I believe that naked short selling is fraud, and should be dealt with as such. It will help reassure investors if the SEC or other law enforcement agency investigated the widespread naked shorting that was happening last year and brought legal action against those that were doing it.
I congratulate the SEC on undertaking this important rulemaking. Putting a strong investor protection in place is essential to the proper functioning of our capital markets. And if those markets continue to fail, our industry cannot innovate, modernize and grow and everyone loses.