The Securities and Exchange Commission today made permanent a rule designed to curtail abusive naked short sales. The rule, Rule 204 of Regulation SHO, is part of a broader package of short-sale regulatory plans announced by the SEC this afternoon.
Underscoring the scope of these plans, the SEC said it would hold a roundtable on Sept. 30 to discuss "securities lending, pre-borrowing, and possible additional short-sale disclosures." This represents one of the SEC’s first big steps into the relatively opaque world of securities lending.
The announcement noted that the roundtable will address the "potential impact of a program requiring short sellers to pre-borrow their securities, possibly on a pilot basis, and adding a short-sale indicator to the tapes in which transactions are reported for exchange-listed securities."
Gregory DePetris, co-founder of Quadriserv, a technology company whose AQS securities lending platform provides centrally cleared stock-loan services, said the SEC "is taking a series of conservative but measured steps toward short-sale regulation." He added that "most of the changes appear to have been considered publicly and weren’t surprising." The AQS platform is growing but remains in its early stages, DePetris said.
In testimony on July 14 before the House of Representatives Committee on Financial Services, SEC Chairman Mary Schapiro said the Commission was exploring "whether additional regulation is appropriate to address potentially abusive short selling. We also are examining a variety of other trading and market-related practices such as securities lending."
The SEC’s statement today was broader. "Today’s actions demonstrate the Commission’s determination to address short-selling abuses while at the same time increasing public disclosure of short-selling activities that affect our markets," Schapiro said in the announcement.
The SEC said it is still considering proposals to implement a short-sale price test and circuit-breaker restrictions. The Commission laid out five proposals in April, in response to widespread public concerns that the elimination of the New York Stock Exchange’s old uptick rule may have exacerbated market volatility and the decline of some stocks last fall. Those proposals generated more than 3,700 comment letters from the public when the comment period ended on June 19, although letters have continued to pour in to the SEC.
Reg SHO’s Rule 204T, which went into effect last Sept. 18, was one of several emergency rules instituted by the SEC in the midst of the financial crisis. The temporary rule was subsequently extended until July 31 of this year. That rule has now been made permanent, as had been expected in the trading industry. The SEC did not make any significant changes to the rule.
The rule imposes penalties on any clearing firm that does not close out a "fail to deliver," or unsettled, position for a short sale by the beginning of trading on the fourth day after the trade date. Settlement is required on T+3, or three days after the trade date. There had been a possibility that the SEC might consider loosening the T+4 requirement to T+5 or T+6, but the SEC’s action has now ended that discussion.
Naked short sales occur when the short seller does not borrow the shares on time to settle the position. Abusive naked short selling occurs when that is done to intentionally manipulate the price of the stock or to avoid the borrowing costs associated with the position.
"Although we recognize commenters’ concerns regarding the potential market impact of the close-out requirements of temporary Rule 204T, particularly at the market open, we believe that these potential effects are justified by the benefits of retaining the strict close-out requirements of temporary Rule 204T," the SEC wrote. The Commission said the larger public benefit was the significant reduction in fails to deliver.
According to the SEC’s Office of Economic Analysis, the average daily number of fails for all equity securities declined 56.6 percent after Rule 204T was implemented, from 1.1 billion shares to 478 million shares. The OEA data compared fails in the period from Sept. 23, 2008, to March 31, 2009, to fails in the period from the beginning of 2008 until Sept 22. The Commission also said it would soon begin to publish fails data on its Web site twice a month instead of quarterly.
The SEC stressed that "fails to deliver may be part of a scheme to manipulate the price of a security. We are also concerned about the negative effect that fails to deliver and potentially abusive ‘naked’ short selling may have on the market and the broader economy, including on investor confidence. The close-out requirements of Rule 204 help address these concerns by prohibiting the persistence of fails to deliver."
Under Rule 204, if a clearing firm does not close out a short-sale position by borrowing the stock to settle the trade, the clearing firm cannot execute additional short sales in that stock without borrowing the stock in advance or having the shares set aside, until after the failed position is settled. The penalty harms the broker-dealer’s ability to facilitate short sales for customers, putting it at a competitive disadvantage to other firms.
The SEC also said it was working with several self-regulatory organizations to make short-sale volume and transaction data available online through SRO Web sites. "This effort will result in a substantial increase over the amount of information presently required by another temporary rule, known as Temporary 10a-3T," the SEC said. That rule, which expires on Aug. 1, applies only to some institutional money managers and does not require public disclosure.
The SEC said it expected that SROs in the "next few weeks" would begin to publish "aggregate short-selling volume in each individual equity security for that day." That information will be published on a one-month delayed basis. The SEC appears to have backed away from the idea of requiring hedge funds and other institutions to disclose their large short-sale positions publicly.
"Instead of renewing the [temporary disclosure] rule, the Commission and its staff, together with SROs, are working to substantially increase the public availability of short sale-related information through a series of other actions," the SEC said in its announcement. "These actions should provide a wealth of information to the Commission, other regulators, investors, analysts, academics, and the media."
