Well I spoke too early.  Over the weekend in the ZachStocks Podcast, I explained that with Congress on a two week holiday, it would be nice to see how this market traded without manipulation from Washington.  But leave it to the SEC to break the peace and issue a proposal to add more regulation to the financial markets.

The latest news has been rumored for a bit of time now and centers around the uptick rule. This uptick rule governed the market since 1937 and basically stated that in order to short a stock you must first wait for the stock to trade up a penny before selling borrowed shares.  But last year after a thorough investigation which found that the uptick rule did very little to stabilize markets, the rule was removed.

The proposal to reinstate this uptick rule will take some time before it is put into action (the standard procedure is to allow for public commentary for 60 days)  And while the measure is likely to be applauded by the general public, I fear that the limits place on the financial markets could yield unintended consequences with very little benefit to individual or institutional investors.

Abolition of Uptick Rule Coincides with Market Meltdown

Proponents of the uptick rule usually point to the fact that within three months of this regulation being removed, the market peaked, leading to what has proven to be one of the all-time historical bear markets.  The argument is that if short selling had been more regulated, prices may not have fallen in quite the same fashion.  To which I say Bull Scheidt! (this is a family show after all)

The most recent bear market was a result of a financial crisis that encompassed irresponsible leverage on both a personal and corporate level.  Access to financing and excessive risk taking bid stocks (and plenty of other assets) up to levels that were unsustainable.  The house of cards was bound to break down eventually and no amount of limiting short selling could have avoided this.

In fact, limits on short selling could actually have accentuated the selloff.  In October of 2008, the SEC posted a massive list of financial institutions that could no longer be shorted.  The market rallied quickly as investors anticipated that a market without short-sellers would lead to gains in the financial sector.  But very quickly the tables turned, markets shot lower and there were no short sellers waiting in the wings to buy back shares.  See, when enough short participants are in the market, they represent a natural buying presence that can actually help support stock prices instead of driving them lower.

What About Existing Rules?

My biggest bone to pick on the SEC regarding short sellers, is the inability to enforce existing rules.  For instance, in order to short a stock, you must technically borrow the shares first.  It’s not fair to walk into a market and declare yourself a seller of an asset that you don’t even possess!

But that’s exactly what many Wall Street firms would do.  For some time it was common practice to short stock and then fail to deliver.  Eventually the firm would buy back the shares and deliver them on a delayed basis, but the practice was illegal and rarely enforced.

Another argument against short selling is that predatory sellers will all-to-often short shares and then start vicious rumors about the company.    This practice is clearly illegal and manipulative!  And if the practice has become widespread to the point where the SEC has to enact rules over the entire market to clamp down on the practice, then someone isn’t doing a very good job of regulating such manipulative practices.

Free Markets are Strong Markets

I guess the bottom line comes down to whether we want free markets or not.  And to a certain degree whether our markets are efficient or not.  If one agrees that our markets are largely efficient, then limits on short selling are basically pointless.  An efficient market can adjust to lower prices because wise managers will see a stock being pushed lower and buy at a discount.  Equilibrium will be established through the natural and rational decisions of buyers and sellers.

But if the markets are NOT efficient, does that in turn lead to regulation in order to penalize those with an advantage?  Shouldn’t all participants in a market (buyers and sellers) have a level playing field without rules stating when and how the actual transactions can take place?  If I have borrowed shares from a party that understands our agreement, and then take those shares to the market (which actively trades these exact shares) shouldn’t I be able to participate in like kind?  You may not like the fact that I am selling, but don’t buyers actually need sellers in order to have someone to purchase from?

And does it rally matter whether you purchase borrowed shares or natural shares?  Either way the shares now belong to the buyer.  If the short seller suddenly is compelled to re-purchase those shares (which can happen because the lender calls the shares back – or because of many other reasons) doesn’t that benefit all owners?  After all, this motivated buyer now represents one of the strongest bidders for the stock driving prices higher.

A Fair Balance of Risk and Return

I think the SEC fails to see that short-sellers are at risk just as much as any other participant.  They live and die based on their intellect and skill in trading.  When shorting one enters a risky position and must bear the losses if he is wrong.  Similarly, a buyer bears the risk of a declining price.  Should we say buyers cannot purchase stock unless the price ticks lower?

In my opinion, the risk / return dynamics are sufficient to provide ample liquidity and a fair playing field for all participants.  The SEC should closely monitor activities of all market participants to ensure manipulation does not happen and fair transactions occur.  But the role of the SEC is not to single out one particular type of market participant and change the rules to discourage fair behavior.  The short sale rule was deemed unnecessary and I believe it should stay that way.

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