An Evaluation Of The SEC’s Naked Short Selling Prohibition

So what exactly was the impact of the SEC’s July 15 emergency order against naked short selling? Not much, shows a study by Arturo Bris, a professor at Lausanne’s IMD business school. He shows that by some measures, it even had a detrimental effect on the market of the very stocks that the SEC sought to protect. For those who missed it, the list was:

Allianz Aktiengesellschaft (AZ), Bank Of America Corp (BAC), Barclays PLC (BCS), BNP Paribas (BNPQF/BNPQY), Citigroup Inc (C), Credit Suisse Group (CS), Daiwa Securities Group Inc (DSECY), Deutsche Bank Group AG (DB), Fannie Mae (FNM), Freddie Mac (FRE), Goldman Sachs Group Inc (GS), HSBC Holdings plc (HBC), JPMorgan Chase & Co. (JPM), Lehman Bros Holdings Inc (LEH), Merrill Lynch & Co Inc (MER), Mizuho Financial Gp Adr (MFG), Morgan Stanley (MS), Royal Bank of Scotland Group plc (RBS), UBS AG (UBS).

The SEC ordered that before anyone could execute a short sale in any of 19 stocks on its list, the hopeful short seller had to locate shares that could be borrowed. For most investors, this was just a reiteration of regulation SHO. We heard from one brokerage firm that went well beyond the scope of the order and banned all short sales in the stocks on the list.

Bris’ study shows that as is often the case when the government gets involved in the markets, the law of unintended consequences took over. Market quality declined in the 19 stocks, which Bris shows through a number of metrics:

  • Daily price volatility decreased after July 15. Bris calculated several measures: intraday (open-to-close) volatility, interday (close-to-close) volatility, trade price (high-low) range and positive and negative semi-variances.
  • Bid-offer spreads have increased more than for other financial firms, and much more than for non-financial stocks. This means that liquidity deteriorated.
  • Co-movements between the stocks on the list and the overall market increased. In an efficient market, individual stocks should be affected only by company-specific news rather than overall market activity.
  • Short selling did not play a role in the deterioration of market quality.

Another findings of the study will give the SEC some food for thought about future restrictions on short selling:

  • The performance of the stocks on the list has been worse than that of comparable firms, but not because of short selling. Weekly short selling activity has little effect on weekly returns. “After controlling for short sales, the performance of [these] stocks is still worse than for comparable firms.” The group underperformed its peers by 10 percent.
  • Shorting activity before the SEC emergency order was highest for firms that were issuing convertible bonds. The implication is that much shorting is done by convertible bond arbitrage funds rather than vicious short sellers who try to destroy companies.

In short (no pun intended), the usefulness of the SEC’s emergency order is highly questionable. The SEC should concentrate on implementing the existing provisions of regulation SHO rather than dreaming up ever new rules.

Besides, we never quite understood why almost half of banks included on the list have their main trading venue outside SEC jurisdiction. Last time we checked, trading volume for UBS, Daiwa, BNP Paribas or Deutsche Bank was infinitely higher in Zurich, Tokyo, Paris or Frankfurt than in the U.S. It looks like regulators wanted to give the appearance of not favoring Wall Street houses by including some stocks for which its order is completely pointless.

Let’s wait and see what the SEC comes up with next. The climate is not favorable for shorting, and in an election year, someone has to take the blame for poor market performance. At least, it’s safe to assume that SEC rules will not be as ridiculous as a recent proposal in South Dakota to ban short selling altogether. And while we’re at it, here’s our tip for overzealous regulators: the housing market won’t recover if you ban short selling of real estate …

Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which has long and short positions in some of the companies mentioned in this post.

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