March 1, 2011

Circuit Breakers for Shorts May Cast Long Shadow

“We determined that it was appropriate to re-examine the appropriateness of short sale price test restrictions.”

We copied that sentence from the SEC’s 334-page charter instituting Rule 201 amendments for short sales. While it’s amusing that the authors modified the word appropriate with the word appropriateness, what’s important is that the rule took effect yesterday, Feb 28. What is it and how might it impact investor relations?

It’s hard to summarize a document consuming 60% of a ream of paper in one sentence. But Rule 201 implements an uptick rule – which regulators removed as part of Reg NMS in 2007 – when securities drop 10% from the preceding day’s closing price. If that happens, an uptick rule will be enforced in which long sellers matching at the best bid or offer will be able to sell ahead of short-sellers, and shorts will only be able to sell if the price ticks up above the last bid.

The idea is that if long sellers get called up to the front of the line, it’ll promote investor confidence by reducing the severity of short-driven price swings. And it’ll improve market-efficiency by letting those with long positions off the boat, thus discouraging short sellers from trying to sink the boat.

Our view? An uptick rule is fair. If your aim is to speculate on price-declines or corner price-setting authority as a market-maker by marking trades short, an uptick rule makes it a bit more complicated.

But these new rules advantage one constituency over others. The laws of scarcity and choice are being engineered for outcomes that would not occur otherwise. It may produce stable markets with a veneer of efficiency. The underlying fact will be greater use of derivatives, more arbitrage, and a flight of dollars in search of value.

Remember, regulators argued hotly about why the uptick rule needed to go, back in 2007. And regulators and congresspersons now complain loudly about derivatives, the dearth of growth and capital, and speculation. Why then more rules that further these woes?

Derivatives are a product of uncertainty. When the value of securities can be clearly ascertained by markets, derivatives are less unnecessary. Arbitragers love rules, because they present a predictable platform upon which bets about divergence can be made. And short sellers are an essential part of a complete value picture. If short sellers are prohibited from pricing securities, value investors become less capable of assigning worth to them.

The majority of short volume today originates with market-makers. They constantly short stocks against the best bid and offer in order to keep prices from moving. Guess what? Rule 201 includes pages of exceptions for market makers to class trades “short exempt.”

What’s more, issuers receive no consistent, standardized data on short sales. How are issuers to measure the impact? In the SEC’s defense, issuers had months to weigh in about these rules. Did your CEO offer a comment letter?

You might think we favor no rules. Quite the contrary. We want simple ones that everyone understands and follows. Rule of thumb: My business mentor used to say, “If you can’t say it in a page, you’re not thinking clearly.”

Rules should not absolve participants of risk, manufacture outcomes, or prioritize buyers and sellers. Most of all, rules in capital markets should first and foremost promote capital formation – matching productive enterprises with the capital willing to take risk for the reward possible in supporting them.

We observed for many issuers that short volume simply disappeared the past four days as all the automated systems that normally produce short volume stopped to adapt. So are the markets really up…or is it just another manufactured outcome?

It would be nice to know.

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