The biggest stock exchanges, after six months of disagreement, forged a consensus and yesterday proposed a modified uptick rule to the Securities and Exchange Commission. This comes in advance of the Commission’s April 8 meeting in which the SEC is expected to propose at least two versions of a price test to restrict short selling.
The rule proposed by NYSE Euronext, Nasdaq OMX Group, BATS Exchange and the National Stock Exchange is designed to “reduce downward pressure on stocks created by abusive short selling” in times of stress. It recommends that only passive short selling be allowed if a circuit breaker is triggered. Thus, only short sales that add liquidity to the market at a price higher than the prevailing national best bid would be permitted once a stock drops 10 percent, according to the proposal. At that point, short sellers would not be allowed to hit bids.
The exchanges are recommending this to put their stamp on a solution to short selling that’s seen as potentially harmful to the markets. “We were able to settle on one concept that we thought would accomplish what a price test was intended to accomplish that was also more palatable from an implementation standpoint,” said Joe Mecane, executive vice president for U.S. markets at NYSE Euronext. “We thought there was a benefit to getting this out in front of the public before April 8.”
A price test imposes a requirement around short-sale transactions that’s based on the price of the stock in question. A bid test, which the exchanges’ proposal recommends, is a version of the price test in which the bid in the stock is used as the reference for short sales.
In the third and fourth quarters of last year, Mecane said, the exchanges had different views about what, if anything, should be done to restrict short sales. He noted that the exchanges reached a consensus as it became clearer to them that the SEC under Chairman Mary Schapiro was likely to consider a new rule regarding short sales.
Discussions last fall revolved around various price tests, including versions of the NYSE’s uptick rule, as well as market-wide or individual-stock circuit breakers. If a circuit breaker were triggered, according to one proposed solution, a ban on short selling would kick in, either for several hours or the rest of the day.
Nasdaq argued against any rule that would ban short selling. “We were not and are not in favor of a ban on short sales,” said Brian Hyndman, senior vice president in Nasdaq transaction services. “We are in favor of the modified uptick rule that we and the other exchanges proposed.” Hyndman commented on the exchanges’ proposal via email to Traders Magazine. He noted that the current proposal was considered last fall, although no consensus about it emerged at the time.
The proposal from the exchanges suggests that only limit orders above the national best bid be allowed once a stock’s circuit breaker is triggered. The proposal did not say how much higher than the best bid the short-sale limit order must be. NYSE’s Mecane said many of the details of the proposal were left for subsequent discussions. Nasdaq’s Hyndman said the limit price should be 1 cent higher than the national best bid. Exchanges could build an add-only order type or create other functionality that enables only passive orders to be sent into the market under certain conditions, Hyndman said.
The proposal’s 10 percent circuit breaker level could get some pushback because a big drop in a stock price is required before the passive short-selling rule would apply. Mecane said the exchanges discussed several circuit breaker levels, and in the end used 10 percent “as a placeholder.”
If any new short-sale rule comes to pass, the onus of complying with it is likely to fall mainly on broker-dealers. Many big brokers have opposed the reintroduction of a short-sale rule, in part because of the difficulty of implementing a short-sale restriction in the current fragmented marketplace. Credit Suisse, for instance, has been outspoken about opposing a reinstatement of the uptick or a version of that rule.
Now, some brokers are more reconciled to the prospect of regulatory change on the short-sale front. Will Sterling, global head of direct execution services at UBS, speculates that the discussion over the next couple of months will probably focus on the details, rather than the concept, of a price test. “We’ve clearly passed the point where people are questioning whether some sort of price test should exist,” he said. “There will probably be very little debate around the structure of the short-sale rule proposal, and a lot of debate about whether the circuit breaker should be 10 percent or 5 percent, or whether there should be no circuit breaker.”
Sterling said the exchanges’ proposal makes sense. “I think the exchanges have put forth a very sensible proposal that attempts to balance the concerns regarding aggressive short selling with the liquidity and [lower] volatility benefits that come from certain types of short selling,” he said. He added that the “tricky part” is the additional technology work required by both exchanges and brokers to put a circuit breaker in place. “It’s probably the right answer, since there are significant market structure benefits to having some sort of circuit breaker instead of a price test that’s always in force,” he said. “But when the entire industry has to make changes, it tends to take quite a while.”
Patrick Fay, director of equity trading at D.A. Davidson & Co. a broker-dealer based in Montana, is more skeptical about the current discussions around a new short-sale rule. He said the exchanges’ proposal will not have a significant impact on the market. “It’s all a facade,” he said. “If the regulators had enforced their own rules about borrowing stock right from the beginning, we wouldn’t have had a problem. This [proposal] won’t change anything of any great importance.”
Fay’s comment refers to the requirement that short sellers borrow the stock they short and deliver those shares within three days of the trade date. Prior to last fall, many brokers were lenient about insisting that short sellers pony up the borrowed stock for their short positions. That led to many “failures to deliver,” in which stock that was supposed to have been borrowed for short sales was never delivered. That drove down the cost of short selling for some firms and created apparent inefficiencies in the market. The SEC last September tightened restrictions around delivery requirements and imposed penalties for failures to deliver. That shrank the number of securities with high fail-to-deliver rates to 20 from 400, according to the exchanges’ proposal.
The Securities Industry and Financial Markets Association expects to weigh in on whatever the SEC proposes in April. “If the SEC issues a price test proposal regarding short selling, we’ll certainly respond and provide constructive comments,” said Travis Larson, a SIFMA spokesperson. He noted that SIFMA has said in the past that bringing back the original uptick rule would be “monumentally difficult,” given the way software, trading infrastructure, decimalization, Regulation NMS and exchange fragmentation have changed the markets. SIFMA hopes, he added, that the SEC will consider the costs and benefits of any new proposals, as well as their potential effects on the market.
Dave Herron, CEO of the Chicago Stock Exchange, emphasizes this point. “Technology and regulatory changes are never cheap, and any rule should take ease of implementation for exchanges and broker-dealers into effect,” he said.
Yesterday’s proposal by the exchanges leaves a number of questions unanswered. One involves potential exemptions to any new short-sale rule. The proposal recommends that exemptions to any new price test be allowed for “bona fide” cash and options market makers. It left the definition of “bona fide” to another day. NYSE Euronext’s Mecane also noted that exemption should be considered for exchange-traded funds. CHX’s Herron, meanwhile, sounded a cautionary note about potential exemptions. “We should be careful with market-maker or other exemptions, to ensure that they’re used only to help facilitate a customer’s execution, rather than to enable the market maker to initiate a principal position,” he said.
