Statement Before the Commission Open Meeting
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
April 8, 2009
Thank you, Chairman Schapiro.
Few, if any, issues confronting the Securities and Exchange Commission in recent months have received as much attention as short selling. Retail investors, institutional investors, issuers, industry experts, broker-dealers, exchanges, academics, pundits, lawmakers, and others have all weighed in — which brings us to today.
We are considering whether to propose the following "short sale restrictions": (1) a modified uptick rule; (2) an uptick rule; and (3) a circuit breaker.
Like my colleagues, I thank the staff for its hard work. I particularly appreciate the efforts of the Division of Trading and Markets, especially Erik Sirri, Jamie Brigagliano, Victoria Crane, and Josephine Tao, as well as the Office of Economic Analysis, especially Jim Overdahl, Stewart Mayhew, Amy Edwards, and Tim McCormick.
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At the outset, it is important to remember two significant regulatory steps the Commission has taken since September 2008 to remedy abusive short selling.
First, the SEC adopted — initially on an emergency basis and subsequently as an interim final temporary rule — an amendment to Regulation SHO imposing penalties if a short seller does not deliver the securities within three days after the sale transaction date. This close-out obligation is directed at curbing "naked" short selling. I look forward to continuing to consider the comments on this rule.
Second, the Commission adopted a final rule eliminating the options market maker exception from the Regulation SHO close-out requirement.
An empirical study by the SEC's Office of Economic Analysis indicates that, in the aftermath of these regulatory enhancements, fails to deliver have decreased significantly.1 This finding should ease concerns over "naked" short selling. Many have viewed "naked" short selling as a particular abuse for regulators to target, while otherwise allowing non-"naked" short selling to occur.
Given the demonstrated efficacy of the enhanced regulatory regime currently governing short selling, the question before us becomes: What additional restrictions, if any, should the SEC impose on short selling? Put differently, what are the incremental benefits and costs of adopting a short sale price test or circuit breaker in light of the steps the SEC has already taken? Do the benefits justify the costs?
The available empirical data drove the Commission's decision when the SEC repealed the "uptick" rule in 2007.2 Careful empirical research by SEC economists and outside academics had found that short sale price tests do not effectively serve their purposes, but do impose costs on markets.3 Central to the SEC's rulemaking was a pilot program that allowed for detailed economic study of the effects of repealing the "uptick" rule.
The Commission's earlier action does not mean that a short sale price test or circuit breaker should not be reconsidered. Indeed, regulators, including this agency, should not adhere to past decisions beyond the point of prudence, but must remain nimble and adaptive as events warrant. That said, it is important to take notice of the diverse body of rigorous economic work that, at a minimum, counsels caution when it comes to imposing a short sale restriction. It is not self-evident that the findings of these economic studies — which supported this agency's prior decision to repeal the "uptick" rule — do not continue to hold in the current economic and financial climate.
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There is much that could be said about the proposal before us. For today, let me take notice of and speak to a leading rationale offered for instituting a short sale price test or circuit breaker. The essential argument is that a short sale restriction, if implemented, would bolster investor confidence, which has deteriorated as we have struggled through serious economic and market strains. Many associate the sharp decline in stocks and recent volatility with the lack of an "uptick" rule, often noting the market's drop since the summer of 2007. I am not aware of an empirically-demonstrated link between recent market conditions and the repeal of the "uptick" rule, and it is important to distinguish correlation from causation. However, one cannot ignore the role of investor confidence in our markets.
Investor confidence is complex and can be elusive. Its justification for instituting a short sale restriction is not so straightforward. Indeed, under certain circumstances — such as the failure of a short sale restriction to serve its intended goals — adopting a short sale restriction actually might erode investor confidence over the longer term, whatever the immediate positive impact might be. Among the considerations to evaluate in this regard are the following.
First, it is difficult to measure how much the lack of an "uptick" rule, as opposed to the recession and other stresses and strains burdening the economy, has contributed to the investor confidence deficit. Accordingly, we must have reasonable expectations for the investor confidence boost that could result, even under the best of circumstances, because a short sale restriction is put in place.
Second, if the economic studies to date prove out — that is, if short sale price tests do not effectively advance their stated purposes — we need to consider how investors might respond. It is worth recalling that financial sector stocks continued to fall during the short sale ban in September 2008. If market conditions deteriorate or even remain flat after a short sale restriction is implemented, additional attention may turn to the real economy's weakness as the source of financial concern. Put differently, the lack of an "uptick" rule could not be blamed for contributing to the market's ills. If it were to play out this way, investor confidence is unlikely to rise.
Third, investor confidence depends on investors' faith in the integrity of markets. Investors look at securities prices expecting that they are meaningful in that they reflect the market's overall assessment of what a company is "worth." Market prices aggregate into a single number available information and the myriad views of market participants.
Short selling is fundamental to the dynamics of price discovery and market efficiency. Because of short selling, investors can be confident that securities prices reflect both optimistic and contrarian perspectives. An unduly burdensome short sale restriction that undercuts the accurate pricing of securities risks eroding investor confidence.
One possibility for addressing this third consideration — and the prospect that short selling restrictions can reduce market quality more generally — is a circuit breaker that allows short selling to occur unburdened by any price test or halt until there is at least some indication — in the form of a steep and quick price drop — of a potential concern. Even then, the price drop triggering the circuit breaker may simply reflect well-founded unease with an issuer that is grounded in the fundamentals.
The concern that a short sale restriction can disrupt market efficiency and other dimensions of market quality becomes acute if there is a temptation to make the restriction more stringent if it does not achieve the desired outcome. For example, assume that the market or even the stock price of a significant company declines sharply after a short sale price test is in place. The next call might be for a more restrictive price test. However, the more restrictive a price test is, the more markets and the economy as a whole lose the benefits of short selling, such as price discovery, liquidity, and risk allocation. More to the point, with a relatively small ratcheting up of the required increment to execute a short sale, a short sale price test can, in effect, morph into a short sale ban. Recent experience teaches that prolonged bans come at a high cost to market quality and, I suggest, investor confidence.
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Because it is important to benefit from additional information and input in light of the current market conditions, I support the proposals before us today. The proposing release will contain an extensive request for comments. Not only should parties address the comparative benefits and costs of the specific proposals, but I encourage commenters to weigh in on whether a price test or circuit breaker of any sort should be imposed at all. I am keenly interested in empirical data and other rigorous analysis. I look forward to considering the comments.
Further, I want to commend the Chairman for committing to schedule a public roundtable. A roundtable provides an opportunity for focused discussion that contributes to a thorough consideration of short sale restrictions, so long as we hear from a range of market participants with a range of viewpoints. I recommend that one of the roundtable panels consist of economists who have studied short selling to ensure that relevant empirical studies receive appropriate attention.
Administrative agencies, including the SEC, are built on independence and expertise.4 Independence allows administrative agencies the room they need to exercise their expert judgment. In the weeks and months ahead, we should not lose sight of this.