Speech by SEC Commissioner:
Reforming Short Sales: Striking a Balance that can Work for Investors
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
February 24, 2010
I join my colleagues in thanking the staff for its work on this difficult issue.
I had hoped that we would be in a different position today. As I have expressed before, the Commission’s oversight of the capital markets is severely undermined by gaping holes in our authority over swaps. As we have all learned, the capital markets are highly integrated. One key lesson is that swaps and other financial products enable traders to take positions economically equivalent to short sales. We have seen how risks taken in the unregulated market have had dramatic consequences in the regulated markets.
I had hoped that, by today, the Commission would be taking up this issue knowing that Congress had passed comprehensive derivatives legislation. Unfortunately, the need for legislation is clear, but legislative action is impossible to predict.
While I continue to urge action on derivatives, the Commission’s work must move forward. The rule we adopt today complements other actions the Commission has taken to address concerns about short selling, especially the failure by some short sellers to borrow shares and deliver them to the buyer. I supported the Commission’s substantial enhancement of the requirements for timely delivery under Regulation SHO, and I am pleased to report that the amendments to Regulation SHO have resulted in a substantial reduction in fails to deliver.1
If every short sale were harmful, or every short sale benign, our task would be straightforward. There is a tension in regulating short sales. Efforts to reduce the potential for short sales to facilitate dangerous declines in securities prices, market manipulation, and diminished market confidence can conflict with efforts to permit short sales for hedging, improved liquidity, and price discovery. I believe that the rule before us today strikes a workable balance.
A central challenge in this rulemaking has been considering the costs in the context of the needs of the market and investors. Investor trust in a fair and orderly market is essential to the operation of the capital markets. It would be a mistake to undervalue this trust because we cannot assign a dollar figure to it. Thus, we have kept this trust in the forefront of our minds. We have also considered the benefits of limiting the ability of short selling to exacerbate price declines. Finally, it was important to me that the price test being adopted today would be easier to implement and less costly than the principal alternatives.
Another issue I have carefully considered is the effect of this rule on certain market participants, such as options market makers. The price test is designed to affect only a small percentage of stocks during most market conditions; it will restrict, but not ban, short sales; it will allow short sales at or below the current best offer price; and it will go into effect only after a 10% drop in a stock’s price. After extensive discussion on these issues, I am persuaded that those who need to sell short for legitimate purposes would be able to do so. And, on the other hand, the rule should restrict the ability of short sellers to exacerbate significant price declines by putting direct pressure on the best bid quoted in the market.
Moreover, as the release notes, the Commission will closely monitor the implementation of this rule, and the staff has been directed to study the effects of the price test on the options markets. I will be keeping a watchful eye on the results. If empirical data demonstrate the need to modify the rule, the Commission can then take appropriate action.
More broadly, the Commission must continue to use its inspections and enforcement powers to police illegal short selling in the markets. However, to be effective at monitoring broader market activity, the Commission must establish a consolidated audit trail for the securities markets. The consolidated audit trail would replace our outdated system with a searchable repository of trading data that would provide the staff with a near real-time view of market activity. As I travel the country and speak with investors, many of them are shocked to learn we do not already have this capability. Our systems need to meet the public’s basic expectations.
In closing, I want to thank the staff again for its efforts and also to express my thanks to the investors, issuers, broker-dealers, exchanges, and others who participated in this rulemaking through the comment process. Weighing the competing considerations at issue in adopting a short sale price test has been a challenging task, and the views that have been shared with us have been valuable and informative. With this assistance, and the staff’s hard work, I believe we have struck a prudent and workable balance that will benefit investors and the markets.
1 In October 2008, the Commission adopted Rule 204T of Regulation SHO and eliminated an exemption to the “close out” requirement of Rule 203. Subsequent analysis by the Commission’s Office of Economic Affairs showed that the average daily dollar value of fails to deliver in threshold securities declined by 89.0%. Additionally, the average daily number of securities on the “threshold list” decreased by 77.5%, and the average daily dollar value of fails to deliver in all securities decreased by 74.8%. See Memorandum from the Office of Economic Analysis (Apr. 16, 2009) (available at http://sec.gov/comments/s7-30-08/s73008-121.pdf).