Politics Dominate the Short-Seller Debate

Bowing to political pressure, newly instituted Securities and Exchange Commission Chairman Mary Shapiro will address the “issue of short-selling regulation, and ensure that any future policies in this area are the result of a deliberate and thoughtful process.”

It is unfortunate that the tidal wave meltdown of financial markets associated with the onset of systemic risk exploded coincidently with the dissolution of the uptick rule. Efficient markets hypothesis suggests that any impediment to expedient price discovery prevents markets from functioning at peak efficiency.

Granted the assumption that short selling has significant psychological impacts, there is no empirical data to suggest artificially damaging results. Where is the outrage over inflated stock prices, irrational exuberance driving stock prices artificially higher?

Lawmakers and regulators have expressed their interest in restoring the uptick rule, where short selling of a security is not enabled until the price of a security moves higher. While the uptick rule might marginally slow the process of driving down a security price, it by no means would have prevented the size and scale of panic selling of the type that ensued following the collapse of Lehman Brothers in 2008.

Proponents of the uptick rule argue that it prevents short sellers from hijacking market momentum who drive prices below what book value would suggest a security’s price actually should be.

Former SEC Chairman Christopher Cox abolished the uptick rule on July 6, 2007 following a study that found the Commission should remove “price test restrictions because they modestly reduce liquidity and do not appear to prevent manipulation. In addition, the empirical evidence did not provide strong support for extending a price test to either small or thinly-traded securities not currently subject to a price test.” The uptick rule was established in 1938 in the wake of the Great Depression to prevent future stock market crashes

Several other suggestions being bandied about by regulators includes modifying the uptick rule, instituting an upbid rule, “circuit breakers” for stock prices, bid-test approaches, and more trading curbs for excessively shorted stocks. Problems abound with most of these suggestions. For example, circuit breaks could have a negative side effect of driving prices towards those benchmark levels simply as they approach those loss levels.

Regardless of the market implications, something is going to get done over the next several weeks. Mounting political pressure will force Shapiro’s hand, whether it be for the market’s good or ill.