Securities Lending Today

SEC Short Selling / Uptick Rule Meeting

Today is the big meeting at the SEC regarding short selling and the uptick rule.  The title of the meeting is “Amendments to Regulation SHO” and the single agenda item is “The Commission will consider whether to propose rules restricting short sales under certain circumstances.”

The questions everyone are “What are the rules?” and “Under which circumstances?”

An Uptick rule was put in place in 1938 and it made it a requirement that no short sale could be executed unless the last traded price was higher than the preceding trade.  The idea was that the rule would remove short selling from the price deceleration of a stock, allowing “long selling” only.  To use the words of Mary Schapiro, Chairman of the SEC, the uptick rule is intended to be a “bit of a speed bump in a declining market”.

The rule was abolished in 2007 when the US stock market was near its highs and was based on research that suggested the removal of the rule would have no adverse consequences.  It was also based on evidence from the 1,000 “pilot stocks” that were already exempt from the rule in a program to assess the impact the absence of the rule would have.  Since then the markets have fallen dramatically and the pressure on politicians and regulators has been inversely correlated.  That is why last summer in a knee-jerk reaction the SEC imposed a ban on short selling of financial stocks.  This move was later described as by Christopher Cox, then SEC Chairman, as the biggest mistake of his career. 

The planned re-imposition of some form of uptick rule was widely telegraphed by Schapiro from her earliest days at the SEC who was no doubt under orders from the Obama administration to take some action and to do it soon.  The clear objective is to give investors, and the public at large confidence that the SEC (and politicians) is seriously concerned with the markets and is doing everything possible to prevent abusive market manipulation. 

In the popular media short selling, and by extension hedge funds, have been demonised as the root cause of the economic meltdown that we are experiencing.  The perception that bear raiders were driving down the value of stocks beyond their fundamental true value is pervasive. That view is not held by most market professionals, and indeed even regulators recognise the valuable contribution of short selling to an efficient free capital market.

Recently the International Organisation of Securities Commissions – IOSCO, the trade body that represents global securities regulators – released its consultation paper (Download IOSCO short selling report) on the Regulation of Short Selling and in its Forward stated:

“The fourth principle addresses that short selling regulation should not stifle certain types of market activities that are critical for efficient market functioning and development.”

So, the regulators acknowledge the value of shorting.

What will today’s meeting cover?  We won’t know until we know, but apparently there are four different proposals that are to be considered, all of which envisage an uptick rule.  The question seems to be more an issue of specific rules rather than a discussion of where or not a rule is appropriate in the first instance.

I just don’t understand this.  There are so many examples of why the uptick won’t make a positive contribution and here are just a couple: 

• The uptick rule was in place during the market crash in 1987, the Dot.Com bust in 2000, and other times of extreme decline and didn’t stop the precipitous falls in any of these periods.  Long sellers were the drivers of the market drops.
• Forget the uptick, during the short selling BAN last year financial stocks continued to fall.

There have been comments that in today’s frenetic marketplace, momentum trading has a disproportionate impact, yet that only seems to be a problem when the market is turning to the downside.  Everyone likes to benefit from momentum trading when prices are skyrocketing – you don’t hear anyone asking for a symmetrical “downtick rule”. 

At first I thought that the rule would be brought back and that would satisfy an expedient political need for Obama/Congress/SEC, but that it wouldn’t have much impact.  I thought that the only people that would be affected would be retail day traders and not market professionals.  I posted a comment to that effect on Twitter and one of my Twitter friends, Urbane Gorilla (twitter.com/UrbaneGorilla) gave me the benefit of his wisdom and I have accordingly modified my thoughts. 

We wait and see the outcome of today’s meeting.  It is expected that a further 60 day consultation period will result. 

I expected this to be a sop to the public outcry for something to be done and I think that is what we will see.  Traders will be forced to accept it, and it will probably end with a whimper rather than a bang.  Again, to quote George Orwell, as passed on by Urbane Gorilla, “The quickest way to end a war is to lose it”.  Bring on the meeting and the consultation period and then let’s get focussed back on the actual market.

To paraphrase Jeff Macke recently on CNBC “if companies want to give short sellers a black eye, they should turn in a good quarter’s performance.”  'Nuff said.

Structural Risks in ETFs / Hedge Fund Redemptions Slow

ETFs

No news yet on the sale of iShares, but that is pretty much all I have been working on for the past week.  And its been fun!

I was reminded of a recent article written by Paul Amery of IndexUniverse.eu.   I got to know Paul while I was at ICAP and he brings valuable practical market experience to his journalism.

ETFs are an increasingly important tool used by investors and in my view will continue to grow in prominence.  Paul’s article examines the structural risks in ETFs and is cleverly entitled “Structural Risks in ETFs”.

Paul answers the following questions:

• What Happens If The Swap Provider Fails In A Swap-Based ETF?
• What Happens If A Borrower Of Securities Defaults?
• What Happens If An ETF Custodian Bank Fails?

You can access the article here.  I hope you find it as interesting as I did.

Hedge Fund Redemptions

The FT carried a story today that gives some anecdotal evidence that hedge fund redemptions are slowing, being cancelled or reversing.  It seems that investors have finally realised that although they may have been disappointed that the hedgies' returns weren't completely uncorrelated to the overall market performance, that the group as a whole outperformed traditional asset managers.  And continue to do so. 

This isn't the end of redemptions and there are still funds that will undoubtedly shut in the days and weeks ahead.  However it does show the beginning of some equilibrium returning to the market.  Bring it on!