Statement Before the Commission Open Meeting
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
April 8, 2009
Short sale regulation is a difficult and complex issue. It is also a topic of great public interest. Many investors, issuers, and other market participants have been vocal in calling for regulation of short sales as a way to prevent "rapid and steep" declines in securities prices, to avoid market manipulation and to strengthen confidence in the markets. They have particularly called for the Commission to reinstate the prior uptick rule. Many others have been just as vocal in calling for the uptick rule not to be reinstated because of concerns that limiting short selling could adversely affect market liquidity and price discovery.
As the independent capital markets regulator, we at the Commission are charged to apply our experience and expertise to protect investors and to maintain fair and orderly markets — in this case by weighing the competing calls for, and against, short sale restrictions and evaluating the need for such restrictions. I have been supportive of having this dialogue for some time, and welcome what I expect will be a robust and fulsome public discussion through the SEC's comment process.
The SEC has an especially important role to play in a time of market turmoil and investor uncertainty. The Commission must respond to the needs of investors.
The proposal before us today is an important step in responding to our duty to serve investors and the capital markets. The proposal seeks to advance the discussion on short selling by providing a framework and process for public participation, and by bringing the agency's technical expertise to bear on the topic. The proposal explains why reinstatement of the prior uptick rule may not be effective in today's market structure, and sets out alternative approaches to short sale restrictions. In broad terms, the alternatives would
- Impose a price test on short sales in declining markets, and/or
- Impose restrictions that would apply only to short sales of a particular stock if the stock price declines in excess of a "circuit breaker" threshold.
This proposal is very much a response to the vocal calls for the Commission to consider short sale restrictions, and we, in turn, are calling on investors and other market participants to carefully react to this proposal. Comments, including those containing quantitative information and analysis, will be vital to developing a robust factual record for decision making.
This proposal does not arise in isolation. For example, the Commission adopted several interim final rules regarding short selling in the fall of 2008, which are due to expire in late summer. I will be considering this proposal in light of those rules and other actions that the Commission has taken regarding short sale regulation.
As we move forward on this important topic, I want to highlight that, without action by Congress, even if we were to adopt a rule restricting short sales, that rule would be, at best, only a partial solution.
There are limits to the Commission's authority that would constrain the effectiveness of any short sale regulation that we may ultimately put in place. For comprehensive short sale regulation to occur, the Commission's authority must be expanded to cover all financial products that are economic substitutes for securities or for interests in securities.
Short sales provide traders with the opportunity to profit from downward movements in securities prices. But other financial products that are excluded from Commission regulation, such as reverse equity swaps and credit default swaps, provide economically similar opportunities. Although short sale restrictions may indirectly affect the availability and costs of some swaps, such as by affecting the ability of swap dealers to hedge their exposure, the effectiveness of any action taken by the Commission may be limited — for example, traders can move their shorting activity to these unregulated products, and continue possibly abusive or manipulative activity in ways that would avoid rules such as those proposed today. Accordingly, Congress must provide the Commission with the power to regulate swaps, so that the Commission can provide consistent regulation across the capital markets.
I know Congress is carefully observing the Commission's responses to the market turmoil, and this rulemaking in particular. As it does so, I encourage Congress to move with all deliberate speed to close the gaping holes in the Commission's jurisdiction.
It is important to underscore the current limits of the Commission's power to regulate in this area. The securities laws expressly prohibit the Commission from promulgating rules that proactively regulate trading in swaps, and prohibit the Commission from imposing reporting or recordkeeping requirements on swaps. These prohibitions apply even when the swap is an economic substitute for a short sale. And they have seriously harmed the Commission's ability to monitor and regulate trading activity.
Let's consider two examples of straightforward swaps that could be used to circumvent Commission restrictions on short sales: credit default swaps, or CDSs; and reverse equity swaps.
Reverse equity swaps are relevant to short sale regulation because they can provide substantially the same economic exposure as a short sale. In general, any strategy where a trader takes a short sale position could be obtained synthetically through a reverse equity swap.
CDSs are relevant to short sale regulation because they permit economic exposure that can bear a relationship to short sales. In addition, CDSs allow traders to express a negative view about the future prospects or creditworthiness of an issuer. Equity prices often move in reaction to CDS prices, providing CDS trading with the potential to manipulate equity prices. While we do not know with certainty whether "bear raids" are responsible for the collapse of Lehman Brothers and Bear Stearns, the shorting of these firms' stock appears to be only part of the story. Trading in credit default swaps on Bear and Lehman bonds may have amplified the downward price pressure on their stock caused by short selling. In addition, market participants have suggested that some traders allegedly engaged in short selling these equities, knowing that the short sales would be profitable because the traders had also entered into CDS positions designed to push the equity price down.
Moreover, restrictions in short selling could simply lead market participants who think a stock price will go down to express that view by entering into an unregulated product. In other words, without comprehensive regulation, we could simply shift activity from regulated to unregulated markets.
Until the Commission has full legislative authority to regulate not just securities, but all financial products that are economic substitutes for securities, any rules the Commission would put in place to restrict short selling may have only a limited effect. In addition, we must consider whether, were we to adopt today's proposals, some market participants would seek to avoid the rules by moving to the so-called shadow markets, and using swaps or other products that are not subject to Commission regulation.
Short selling is an important topic of interest to investors and other market participants, as well as Congress. Today's proposal will advance the discussion of this topic, and help develop a robust record for decision making. I also hope that this proposal will highlight for Congress, investors, and other market participants, the need for action to close the gaps in the Commission's authority over swaps and other economic substitutes for securities.
Notwithstanding the gaps in our authority, I support today's proposal. The SEC's rulemaking process will provide valuable structure and technical expertise to a matter of great public interest. I encourage investors and other market participants to observe and comment on this matter, including on the Commission's upcoming roundtable on short sales.
I thank the staff again for their hard work in developing this proposal, and their thoughtful and careful approach to the alternatives it sets forth. I note that the proposal contains close to 200 questions for the public. I have a few questions for the staff.