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January 2, 2007

Price Test Rules for Short Selling Go Under the Microscope

By Peter Chapman

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  • Price Test Rules for Short Selling Go Under the Microscope

For the past year-and-a-half, traders have been able to do something they couldn't for the previous 67 years: short stock on a downtick. Not since before 1938, when the Securities and Exchange Commission first imposed restrictions on short selling, at a time when the shorts were vilified for causing the stock market crash of 1929, have the shorts had it so easy. In May 2005, as part of an effort to reform the industry's rules governing short sales, the SEC launched a pilot program allowing traders to short the market's 1,000 largest securities without restriction.

The pilot, or Rule 202T, is part of a package of rules comprising Regulation SHO. It is slated to end next August. At that time, the SEC hopes to be able to decide whether or not restrictions on short selling should be eliminated, beefed up or otherwise modified.

Specifically, the SEC might (a) abolish its own tick test rules, (b) adopt an across-the-board bid test or (c) leave in place the current tests.

Many in the industry would like to see the restrictions purged from the rulebooks, but not all. New York Stock Exchange specialists, for instance, favor restrictions. That's because specialists are sometimes required to act as buyers of last resort.

According to one study, short selling accounts for 23 percent of all sales on the New York Stock Exchange. Short sellers are generally considered to be speculators seeking a profit or brokerage house employees such as market makers managing their positions.

Bear Raids

The Reg SHO pilot temporarily eliminated Rule 10a-1 of the Securities Exchange Act of 1934 and former NASD Rule 3350.

Rule 10a-1 was put into place way back when for two reasons: to prevent short sellers from driving down prices (bear raids) and to stop them from accelerating declining markets.

The SEC's Office of Economic Analysis (OEA) and other financial economists have been conducting studies into the impact of the pilot on market quality. They are also looking at the impact on the practice of short selling specifically.

The initial reports are now starting to trickle in. The SEC recently held a roundtable with a dozen prominent financial economists to discuss the OEA's findings as well as those of three groups of academics.

The studies examined the performance of both pilot and control stocks both before and after the pilot, which started on May 2, 2005. Their conclusions were largely similar, finding that removal of the price tests had no appreciable effect on the marketplace.

Market Quality

Furthermore, what impact there was, was more pronounced on the NYSE than in the Nasdaq market.

Among the conclusions were that short selling increased on the NYSE, but not as much in the Nasdaq market. Spreads increased and liquidity decreased on the NYSE to a certain extent. That's because short sellers no longer used limit orders to achieve their goals.

Also, the size of short-sale trades decreased on the NYSE, but remained unchanged on Nasdaq. Volatility did not increase in either marketplace.

"Is the pilot representative of what trading would be like if the rule were applied across the market?" Bob Colby, the deputy director of the SEC's division of market regulation, asked the experts.