May 26, 2009
We recommend that the SEC not implement a new short sale restriction. However, if it must, we urge that there be a complete and permanent exemption for options market makers, whose ability to conduct business depends on quickly hedging unwanted directional risk resulting from providing liquidity in the options markets. Further, we recommend that any restriction be consistent through time, such as the up-tick rule that had been in place through 2006, as opposed to a “circuit breaker”-style rule that only takes effect when the market, or a particular stock, is down by a certain amount. Below, our reasoning.
1. Any short sale restriction should include a complete and permanent exemption for options market makers.
Options and equities are traded in fundamentally different marketplaces. Due to the large number of options strikes available, market makers are vital to ensure fair and orderly markets; these market makers are able to provide liquidity thanks to meticulous and continuous risk management practices, and cannot do so effectively if they are prevented from quickly hedging unwanted directional or “delta” exposure by executing trades in the underlying asset (i.e., in the case of equity options, shares of stock). After transactions that result in the buying of calls or the selling of puts, the market maker must sell stock to reduce risk; often, the market maker does not own the stock in question and so the trade is a short sale. Far from being speculative or abusive trading, this is a risk-reducing hedge to facilitate the provision of liquidity to investors. Restricting these transactions for stocks that are not difficult to borrow, simply because the price at which the market maker is trying to exit his or her stock position is not an uptick, will lessen the ability of market makers to provide liquidity—thereby increasing volatility in the options markets while providing no offsetting benefit to the public.
Furthermore, any short sale restriction without an options market maker exemption will directly increase costs to customers. Given that market makers will be restricted in their ability to reduce risk after selling puts or buying calls, market makers’ posted put offers will naturally be higher and their posted call bids will be lower. This will increase the cost of portfolio insurance (i.e., buying puts) to customers, and will reduce the benefit to customers who write covered calls to increase portfolio income. Moreover, such a rule would not reduce the risk to market makers from buying puts or selling calls, so posted put bids and call offers will remain unchanged; as a result, the net impact, will be to widen the bid-ask spreads paid by the investing public, a stark reversal from the spirit of such longstanding options-market initiatives as the Penny Pilot Program.
2. However, the SEC should not implement a new short sale restriction at all.
Short sellers serve an important function in the marketplace, providing liquidity and reducing the risk of speculative bubbles. Current regulations already prohibit abusive practices such as naked short selling of hard-to-borrow names; we support the SEC’s recent actions to crack down on violations of these important prohibitions. It’s not clear, however, why further restrictions should be placed on legitimate short sales. If short selling on downticks is restricted, willing buyers will be prevented from trading with willing sellers—ultimately increasing the prices some investors will have to pay for their shares.
Much media ink has been spilled (and many public-company executives have made CNBC appearances) claiming that a short sale restriction might reduce “unfair” downside volatility. But these arguments neglect to mention that short selling also prevents “unfair” upside volatility—i.e., speculative bubbles that can be catastrophic for investors who get into the market too late, as happened with Internet stocks in the late ’90s and more recently with real estate. We have yet to see an argument for a restriction on short selling on downticks that could not be applied, with equal validity, to a restriction on “long buying” on upticks. The fact that no such proposal is in the offing suggests that the symmetric proposals restricting short selling rest on equally shaky logical ground.
Furthermore, multiple academic and industry studies have demonstrated that short sale restrictions do not significantly reduce volatility (indeed, it stands to reason that any activity that restricts trading will reduce liquidity and therefore, in general, actually increase volatility). In the past, SEC officials have cited this research in support of lifting the original short sale restrictions several years ago—a policy we supported at the time, and continue to support.
3. If a short sale restriction is instituted, it should be applied at all times—without “circuit breakers.”
If circuit breakers are used, then as the market declines, it will be more likely to pick up speed as people race to unload long positions before the circuit breakers are invoked. Circuit breakers disproportionately reduce liquidity during precisely those moments when it is most needed, and may act as “magnets” on prices to the downside. They introduce distortions in the marketplace, creating perverse incentives for investors to “rush for the exits” during what might otherwise be only a modest downturn in a particular security. Furthermore, the costs of building systems to track which names are impacted by the circuit breaker at a given point in time will inevitably be passed along from Wall Street firms to the investing public.
Vincent Florack, Steve Crutchfield
Matlock Capital LLC