May 2, 2009
I would like to comment on the proposed short selling restrictions, Rule Release No. 34-59748.
The process of short selling is an integral part of price formation in the market. Having short sellers correctly identifies those that want to sell a stock because they believe the fair value is below the current value. These are the findings that were found in the Securities and Exchange Commission in 2004 and then presented by outside consultants in 2006.
By creating an up-tick rule artificially impedes this price discovery. If there are more sellers than buyers then the price is naturally going to decline without further increase or uptick in the price. Consequently the market will naturally find the price equilibrium between buyers and sellers.
As for the increase in volatility, the increase was due to market forces that expected lower volatility in the markets when in fact there was higher volatility. The VIX was abnormally low for several years. The spike in the VIX was a natural process of reversion to the mean after a long spell of investors reducing the equity risk premium and not accounting for increased leverage that investments banks and the shadow banking system created.
This is not to say that short selling should not be restricted. Short selling should be restricted to the shares that can be borrowed. The practice of naked short selling where sellers have not borrowed the stock, but are able to short the stock anyway is a misalignment of market forces because it artificially creates more sellers than can be had in the market. By restricting short selling to those that can borrow shares you keep the price discovery process orderly. In other words if you have 100 seats to fill a movie theater you can only sell 100 seats. But if you sell 120 seats at least 20 individuals are going to be disgruntled because they were promised seats and did not receive seats. In the same way, if there are more short sellers than shares available the equilibrium is disturbed because you are allowing sellers to pile on to a falling stock when those shares do not exist and therefore creates more sellers than buyers. Specifically, you can't get to equilibrium because by definition the numbers of buyers can only be as many shares that exist in the market, you cant have more buyers than shares that exist on the market. But if you have short sellers that can not borrow shares than there are more sellers than buyers and the price equilibrium can not be determined.
Therefore, I urge the commission to stop either a permanent or temporary price control of short selling by using some form of an uptick rule and focus the commissions efforts on discontinuing short sellers from selling stocks short where the sellers have not been able to borrow shares.