May 27, 2009
Comments on the issue of short selling regulation to the SEC. -- 5/22/2009
With respect to the financial markets, the SEC is charged with the responsibility to "regulate commerce" as empowered by the U.S. Constitution Article I Section 8. I have observed that the removal of the short selling "up tick" rule has destabilized the financial markets. Whether such actions are a result of inept, careless management or some other cause, this constitutional mandate remains. In the economic sense, short selling is not properly "commerce" because, there is not a reasonable willing buyer and a reasonable willing seller. Regulation of such transactions are nearly impossible because neither the buyer nor the actual owner of the stock is aware that the stock is being sold short. The brokers do not exercise a fiduciary responsibility in this matter because of the terms of the margin accounts with their clients. Even if complaints are lodged with the SEC, the tracking of naked shorts is not possible because of the resources available to the SEC. Thus, such transactions are tantamount to a "Quit Claim Deed" to the Brooklyn Bridge and, as concealed as, the token in a shell game. Only in the "covering of the short" are the events back in balance. Regulate, is defined in my dictionary as: "to adjust to a particular standard, rate, degree, amount, etc." It is impossible to regulate what is not known.
From a macroeconomic standpoint, I think short selling is not in the best interests of the economy. It increases the traded supply of stock, dilutes its value, irrationally depresses the price of the stock, and increases the volatility of the stock. It is also self-serving since, only the broker and the short seller benefit from the trade -- The real owner did not intend to sell the stock A short seller could "sell" stock that is not owned to repurchase the same stock later at a lower price for a profit and in the interim, use the proceeds of the "sale" to fund another transaction. Such activity is akin to using counterfeit money to capitalize a bank.
The stock market was intended primarily to offer a means of capitalization and joint ownership of a business with a degree of liquidity that enables that business to thrive and produce wealth by providing time, place and/or form utility. The owners of the stock have liquidity through the stock market by selling their stock for a price based upon the fortunes of the company and the demand for the stock. Short selling undermines these goals by irrationally depressing stock prices while increasing its volatility and, thereby, disrupts the process of commerce.
Some argue that concerted buying or selling -- bull raid or bear raid -- should both be allowed. These are not comparable. The bear raid is conducted without a willing knowledgeable buyer and seller and it generates a liquidity for the sellers from a stock which they do not own. Whereas, the bull raid is conducted by borrowing money on margin to purchase stock. With these borrowed funds, upon which the buyers owe interest, they hope to sell the stock, which they legitimately own, at a higher price. The allowed margin requirement limits the activity. The macroeconomic effect is self-correcting and generally negligible. By contrast, the bear raid generates liquidity for sellers of a promise and is not similarly regulated through the process and, therefore, it can be completely out of control The motivation of short sellers is dependent primarily upon the continued depression of the stocks price and is irrational with respect to other economic events that normally drive stock prices. It does not provide more than a shallow market for other sellers in a short squeeze. Such bear raids as evidenced by the stock prices for Bear Stearns, Goldman Sachs, et.al., destabilized the market in general with unjustifiable volatility and destroyed the fortunes of many in the fourth quarter of 2008. There are others means, such as options, to bet on the price decline of a stock without "selling short." Option activities do not affect a stocks price so directly.
The elimination of all short selling seems, at this juncture, too lofty a goal to be realizable, even if, desirable. Therefore, one must consider what regulations are just necessary and just sufficient to assure the investing public that the stock market is both a reasonable and profitable investment vehicle.
I have reviewed the SEC's proposals and I am not convinced they would provide sufficient stability in this present economy. The scope and style of trading is quite different today as compared to 50 years ago and the opportunity for market manipulation is much greater.
However, developing sufficient regulations which would accommodate short selling is not difficult. I would suggest that short selling be allowed so long as it does not substantially affect the nominal variations experienced in the market of any stock when short selling is not present. I believe that this could be accomplished by limiting the amount of stock which is "shorted" in any day to 3% of the 10 day average daily volume and further limit the total outstanding "shorted" stock to 1% of the outstanding shares of stock for each issue. Such a rule can easily be handled by the electronic trading mechanisms already in place and it discounts the enforcement problem of "naked shorting" since, the maximum effect of short selling under these restraints is probably negligible.
Jim Fassell -- Goleta, CA