Given the opportunity to comment on the Securities and Exchange Commission’s proposal to amend its Regulation SHO with a new rule curbing short sales, traders overwhelmingly trashed the idea in letters to the regulator submitted in the past two months.
However, faced with the prospect the SEC was taking its marching orders from a U.S. Congress adamant about a return of Rule 10a-1, or the "uptick" rule, the industry is reluctantly endorsing two of the SEC’s five proposed rules.
Traders almost overwhelmingly rejected the proposals for an all-day, all-securities price test restriction based on either the last sale (Rule 10a-1) or the consolidated best bid.
If the SEC must do something, they suggest the regulator go with a circuit breaker approach that applies a rule only to specific stocks, and only when they fall by a certain percentage.
"SIFMA firms generally believe the circuit breaker approach is more favorable than a market-wide price test," the Securities Industry and Financial Markets Association told the SEC. "Most firms favor a price test that would be narrowly tailored toward certain stocks that have tripped a circuit breaker, while not impacting other securities."
The SEC offered the industry two all-day, all-securities options: a price test based on the last sale and one based on the consolidated best bid.
The regulator also gave traders the choice of three circuit breaker options. Two would trigger one of the above-mentioned price tests. The third would result in a halt of short selling for some specified period.
Most industry pros are leaning to the circuit breaker coupled with some sort of bid test although some of the purely electronic firms believe a halt is the better option.
The Managed Funds Association, which represents hedge funds, likely to bear the brunt of any new rule, supports a circuit breaker/bid test. It opposes a halt, telling the SEC "it would exacerbate market conditions and eliminate key hedging and risk management activities at potentially a very difficult time."
Supporters of the circuit breaker/halt option say price tests, whether market-wide or stock-specific, would be costly to implement and difficult to comply with. Lime Brokerage, an order-routing broker-dealer catering to high frequency traders, prefers a halt. "It would be effective in providing a ‘time-out’ to the market during which no short selling would be allowed," Lime told the SEC.
SIFMA noted a short sale halt would be the "easiest and most cost-effective to implement, and would also be easier to comply with than a bid test, which could be subject to bid flickering."
TD Professional Execution, another order-routing brokerage, believes a circuit breaker/halt is superior to a circuit breaker/bid test because it would not require an investment in new technology or policies and procedures to prevent violations.
Supporters of a short sale halt maintain compliance with a bid test would be impossible because firms take in market data at different speeds. Thus firms base their trading decisions on different quotes. Credit Suisse, which operates one of the Street’s largest electronic trading operations, holds this view.
A price test utilizing the best bid does rank higher than one referencing the last sale. Most players reject the idea of a circuit breaker/uptick rule for the same reason they reject a blanket uptick rule–because trades are reported out of sequence, it is impossible to determine if the most recently reported last sale was higher or lower than the previous.
Short sale price tests do not ban traders from shorting. They only dictate the minimum price at which a trader can short. The old uptick rule, for instance, allowed traders to short at the last sale if the market was moving up, but required them to sell at an increment above the last sale if the market was moving down. Under no circumstances could they sell short at a price below the last sale.
The SEC’s circuit breaker/bid test proposal would allow traders to short at the best bid if the market was moving up, but would require them to sell at an increment above the best bid if the market was moving down. Under no circumstances could they sell short at a price below the best bid. While some industry players are okay with this plan, others have offered alternative bid tests.
Some of the exchanges and ECNs, for instance, prefer a more restrictive rule. They want one that only permits shorting at prices higher than the best bid, regardless of whether it is higher or lower than any previous best bids. Under their plan, traders could only short by posting an offer; they could not hit the bid. This "passive" shorting rule is easier to implement and police, the exchanges maintain.
At the other extreme, a group of hedge funds–Citadel Investment Group, D.E. Shaw, and Renaissance Technologies–prefer the SEC adopt the old NASD Rule 3350. This short sale rule is less restrictive than the above-mentioned bid test proposals as it allows shorting at any price. That includes prices lower than the best bid, as long as the most recent bid is an upbid.
Regardless of whether a circuit breaker rule is coupled with a bid test or a temporary ban, traders are concerned that a 10 percent drop, as suggested by the SEC, might be too small and would trigger a rule too frequently. Citadel, and others, state that at a 10 percent threshold each stock in the S&P 500 index would become subject to a rule an average of one to three times per year during normal market conditions.
The hedge funds and others argue the percentage should be calculated based on a stock’s volatility and other factors. Stocks trading for less than $10, for instance, might be justified with a higher threshold such as 20 percent, they argue.
Firms also argue any price drop should be measured from a stock’s opening price rather than the previous day’s close, as the SEC proposed. In addition, they suggest it might be wise to "turn off" any short sale rules if the stock’s price recovers enough.
