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STA Rejects Trading Limits for Short Sales, Advocates Pre-Borrows
Traders Magazine Online News, May 7, 2009
Unhappy with the five current proposals from the Securities and Exchange Commission to restrict short selling, the Security Traders Association has come up with a sixth.
The STA on Monday recommended that the Commission adopt a mandatory pre-borrow triggered by a circuit breaker to restrict short selling. This proposal targets the abusive short selling at the heart of concerns about short sales, which the SEC's current proposals miss, the group said.
The STA proposal does this by seeking to curtail short selling by those actively trying to drive down the price of a particular stock. It does not seek to restrict all short-selling activity in that name. However, this proposal also has its skeptics.
"The SEC's current options are based on mechanical trading functions, while our proposal will economically impact the short sellers," Peter Driscoll, chairman of the STA and senior equity trader at Northern Trust Company, told Traders Magazine yesterday at the group's annual Washington, D.C., meeting. He said trading constraints based on ticks or bids do not present much of a hurdle for short sellers in a fast-moving market in which bids can move up and down within a single second.
The STA advised the SEC not to adopt a trading rule around short selling, but to instead require short sellers to pre-borrow shares for short sales if the stock in question declines 10 percent from the previous day's closing price. In making this suggestion, the STA rejected the five proposals put forth by the SEC last month. These include two price tests (one based on ticks, the other on bids) and three circuit breaker-based solutions intended to constrain short selling.
A pre-borrow refers to the need to borrow shares to settle short sales before the execution takes place. Currently, firms must have "reasonable grounds" to believe the shares can be borrowed by the settlement date, which is three days after the trade date, but they do not have to borrow the shares in advance.
Under the STA's proposal, exemptions to the re-borrow requirement would be allowed for bona fide market makers in equities and options, as well as for domestic and international arbitrage trades. However, if the stock dropped 20 percent from the previous close, those exemptions would disappear, requiring everyone to pre-borrow shares. At 30 percent, short sales would be banned for the rest of the day.
"The current discussions on how to combat abusive short selling and the attributed volatility have been trading-centric," the trade group said in its letter to the SEC outlining its proposal. The STA said tick tests and bid tests have been "rendered ineffective by structural changes to the markets and that price tests would be unable to dampen volatility even if they were to be reinstituted." The SEC eliminated all price tests, including the New York Stock Exchange's uptick rule, in July 2007.
At an STA panel on short selling on Tuesday, Driscoll told the audience that "we should promulgate rules for problems, not politics." He said the SEC is responding to political pressure from Capitol Hill and public outcry focused on short selling without differentiating between harmful practices and short selling that is part of legitimate trading strategies.
The STA letter noted that its solution addresses the real problem of abusive short selling, which typically involves deliberate naked shorting (in which a short seller makes no attempt to borrow shares to settle short sales). This solution, the group said, also avoids interfering with the price discovery process by not curtailing short selling the vast majority of the time.
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