June 19, 2009
As an introduction, I worked under Harold Gibson at the Toronto Stock Exchange, a managing director and the architect of many of the principal trading rules in North American equities trading. I also worked under John Carson and John Kolosky at the TSE, who are prominent in principal trading regulation and instrumental in the task of increasing my awareness and developing my understanding of fair and equitable practices in the context of trading regulation.
In addition, I have spent twenty years with international investment banks covering fixed income investors, specializing in fixed income, structured credit, credit default swaps and related fixed income derivatives.
Providing investors with a level playing field is the top priority for the SEC. Slanting the trading rules to benefit increases in asset values through the implementation of certain conditions for short sale execution is a disservice to the guiding principle of fair valuation for asset prices.
Firstly, inappropriately elevated share prices ultimately lead to unfair share price volatility. Volatility has become a tradable commodity it can be positioned in portfolios through option strategies and can be received (or paid) in variance swaps. It is also an important component in the valuation of assets. Artificially elevated volatility levels lead to structured finance positions that are the impetus behind quantitative investment strategies, a source of analysis that influences multi-billion dollar trading positions.
Pricing bias created by short sale restrictions therefore impacts strategy by creating an artificially high volatility component to asset valuation. Elevated volatility is the impetus for a number of trading strategies, and manipulating volatility is clearly inappropriate. In the purest sense, an economist can demonstrate that elevated volatility is analogous to higher interest rates, in the sense that the rate of return from traded volatility is higher than it would be otherwise.
Economic interests are clearly distorted by elevated share prices. The cost of purchasing, or financing the purchase of a business that maintains restrictions on short sales bears an economic cost to the buyer through elevated costs, elevated debt levels costs that are theoretically passed on to consumers. Through a multiplier effect, this is clearly a source of inflation.
As a barometer of economic value, inappropriately elevated share prices are a fine advertisement for investment fair play principles dictate that inappropriately valued assets are not the goal of regulation. Ensuring the integrity of the markets and providing equitable trade positioning between buyers and sellers of shares are clearly the goal of regulation.
The recent rescission of the uptick rule is the result of a fair evaluation of the process of short sales. It is the correct decision, based on the reality of the fair markets process, liquidity of the markets, and appropriate expression of a market view. To put it into another perspective, would it be equitable for buyers of shares to need a down or sideways tick in order to go long? Why would we support such bias in our trading rules?
This forum is an opportunity to review the process of strengthening the decision, and tying up loose ends within the trading process.
I would like to propose a review of the following issues, in order to correct the inexplicably permissive environment enveloping short sales.
Firstly, naked (or uncovered) short sales are clearly the disruptive mechanisms that facilitate economic upheaval. This contrasts with covered short sales, or short sales where the underlying security has been borrowed at a financial cost in order to facilitate delivery on the scheduled settlement date.
Naked short sale effects are clearly apparent in the feeding frenzy that took down Lehman, testament that speculators who are able to sell shares without delivery can result in sell side volume that challenges, or even exceeds, the natural float in existing shares. Such an imbalance is unnatural, inappropriate and has historically resulted in regulatory concerns (or lack thereof) for share price manipulation.
Uncovered short sales pose an unseen cost to the underlying company, a concern that is given little attention. Companies rely on bond and stock issuance in order to raise capital, and are very sensitive to the valuation of their issuance from treasury. Furthermore, such issuance is highly regulated, monitored and controlled.
Uncovered short sellers are clearly increasing the amount of outstanding shares by selling unborrowed shares into the marketplace. This activity serves to lower the value of the underlying shares, and if the company seeks to initiate a secondary issuance of shares, is doing so at an economic disadvantage. The point of this is, uninvolved third parties should not be allowed to artificially impact the costs of any company from obtaining market value for issuance of their own shares. I believe this is a fundamental principle that should govern the trading rules involving short sales.
This notion is demonstrated to the extreme in the credit default swap market, where companies are uninvolved in the issuance of synthetic bonds of their own company name.
Recent turmoil has ultimately resulted in the dramatic widening of corporate spreads to the point that companies access to reasonable funding rates is precluded by synthetic issuance that dwarfs the actual outstanding company debt by multiples of 5 to 20 times.
Simply put, this puts an economic hardship on the underlying company.
We constrain buyers by demanding payment we must contain sellers by demanding delivery. This reinforces the notion of orderly trading.
Covered short sales can be managed on several fronts.
Federal Reserve Chairman Ben Bernanke recently demonstrated taxing fails-to-deliver in government bond trading significantly reduced the amount of naked shorting. Layering an economic cost to shorting any underlying asset curtails the short sales, and more importantly keeps the selling volume restricted to an amount appropriate to reasonable capacity for the underlying security.
This principle can be extended to manage short sellers, that is, an economic cost is entirely appropriate to shorting securities. This is typically expressed in the repo market, but can also be elevated to higher or lower borrowing cost levels in order to respond to market conditions.
If regulators are to effectively regulate short sales, an understanding of the repo market and settlement process is vital to this interest.
Another area for managing short sales is to regulate the ability for certain types of funds to loan stock. In my view, it is entirely against the economic interests of a pension plan, endowment, public entity or any such fund to loan shares for the up-front economic benefit versus the contradictory selling interest they create, thereby undermining the value of the asset they hold. The short-term benefits of stock loans are not perceived to be related to increased selling activity, but clearly, there is a linear relationship between share loans and share sales. Market participants do not borrow shares without the express intent of selling the underlying security. Managers of public-interest funds should not be allowed to ignore this vital implication.
Share loans are not consistent with the investment goals of any fund. Generally share loans are perceived as incremental value in an innocuous activity, without taking ownership for the economic cost that is inflicted on the underlying portfolio. Such de-linking of process can occur in private funds, but the public interest is not served by professional managers of public funds who cannot connect the implications of stock loans to the investment performance of their fund. Undermining their portfolio positions is classic short-term gain with no consideration of the long-term pain.
Historical evidence of the negative impact of such tactics lies in the review of on-book valuation of incremental profit (stock loan revenue) versus the down-the-road impact of their actions, as in such cases where swap counterparties have exchanged cash flows to offset interest rate differentials in interest rates. This has in many cases, where the investor has known or perhaps not, resulted in an up-front exchange of cash flows that benefits the portfolio in the immediate circumstance, and makes the financial manager appear profitable. This up-front benefit is either mitigated over time through elevated rates to the managers fund, or worse, balanced by a termination payment that must be made long after the departure of the initiating manager. We see this often in municipal finance, where the expertise of the execution can be scrutinized, or where managers seek to improve their financial condition for the term of office they occupy.
Another example lies in the portfolio valuations claimed by Joe Jett of Kidder, who claimed incredible profits based on complicated cash-flow manipulation, contrary to the firms total cost over time. Financial engineering allows managers to front load their cash flows at the expense of future valuation.
It is clear that failure-to-deliver allows behavior that is unfair to the notion of orderly trading.
As an immediate remedy, I propose that the SEC review the implications of an adjustment to the current buy-in rules. There is no reason to allow unsettled trades to undermine the integrity of the settlement process. Allowing weeks to pass before permitting the buy-in process to kick in allows free riders to engage in illegal and harmful short sales.
The point can also be made that sellers of securities must simply be prepared to sell securities, meaning sale and delivery. Persons unable to deliver are clearly not prepared to sell, and should be restricted from selling until they are prepared to make delivery. This should be a clear point of efficiency in trading execution. It would serve to clear up many backlogs and the associated costs among market participants.
The only condition where I believe short sales merit any type of exemption lies in the market-maker aspect of providing liquidity. Market-makers are subject to flows that may leave them with a short position at the end of a day. A minor extension of time, or the ability to fund short sales at a preferred rate might be suitable to encourage liquidity-providers to remain engaged in the process of market-making.
Lastly, covered short sales are a part of the execution of a market strategy, and require proper access to company shares. It is up to market forces to understand and calibrate costs and the access to share loans.
This is the goal of regulation in short sale execution – orderliness and legitimacy in execution.