What the SEC Really Did on Short Selling

The Federal Reserve’s decisions to offer credit to its 18 primary dealers — and to extend these credit facilities to Fannie Mae and Freddie Mac, complementing the recent Treasury proposal for authority to back their debt and buy their equity — are highly unusual. Because they break with the norm that markets should decide which firms fail and which succeed, both the Fed and Treasury proposals are intentionally limited in duration. But if policy makers want to return these firms to the discipline of the market, the lessons of the recent turmoil will have to be quickly taken to heart.

Already, heeding one important lesson, both the Securities and Exchange Commission and the Fed have strengthened liquidity and capital tests for the firms we regulate. Another central lesson is that financial institutions, which depend on confidence, are uniquely vulnerable to panic fueled by suspect information and market manipulation.

A run on a bank can take hold quickly, and can be fatal. In the wake of IndyMac’s demise and Bear Stearns’s desperate sale to JPMorgan Chase, even far-better capitalized financial firms may be threatened. What’s needed now, therefore, is reliable information for investors, and confidence that trading can be conducted without the illegal influence of manipulation that can fuel stampedes.

When an irrational panic is fueled by false rumors that investors believe must be acted on immediately — lest everyone else get out first — market integrity is threatened. In such circumstances, it is the job of market cops to provide a measure of confidence that information about public companies is accurate — and when it is not, to punish those responsible.

Who profits from intentionally false information in the marketplace? Those who are in on the scam and positioned to benefit from the predictable response of people who believe the fraudulent information to be true.

The classic “pump and dump” scheme, in which a stock is inflated through false information and then dumped on unsuspecting investors when the perpetrators flee, is one example of how this works. “Distort and short” is the same thing in reverse.

“Naked” short selling can turbocharge these “distort and short” schemes. In an ordinary short sale, one borrows a stock and sells it, with the understanding that the loan must be repaid by buying the stock in the market (hopefully at a lower price). But in an abusive naked short transaction, the seller doesn’t actually borrow the stock, and fails to deliver it to the buyer. For this reason, naked shorting can allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions.

Last week, in close consultation with the Treasury and the Fed, the SEC issued an order to further the objective of existing commission rules that restrict naked short selling. It applies to precisely those financial firms that the Fed has designated as eligible for access to its liquidity facilities — and for which the taxpayer could be on the hook.

The order carefully protects legitimate short selling in these securities. Our agency’s rules have long been supportive of short selling, which can help quickly transmit price signals in response to negative information or prospects for a company. Short selling helps prevent “irrational exuberance” and bubbles. Continued legitimate short selling in the securities of these financial firms will act, as it is supposed to, as a way for market participants to invest in the downside and to hedge other positions.

Illegitimate naked short selling is different. In the context of a potential “distort and short” campaign aimed at an otherwise sound financial institution, this kind of manipulative activity can have drastic consequences.

Eliminating the prospect of naked short selling will help assure investors that it is safe for them to participate, and that when the market declines it is not because of unseen manipulators and “distort and short” artists.

The emergency order is not a response to unbridled naked short selling — which so far has not occurred. Rather it is intended as a preventative step to help restore market confidence at a time when that is sorely needed.

When the SEC announced this order, I also made clear my intention to ask the full commission to apply operational protections against abusive naked shorting to the broader market. The scope of last week’s action is based on the Fed’s designation of those financial institutions to which our government and the taxpayers will now temporarily provide liquidity, but its rationale extends to all public companies.

Although the Commission’s order was issued under emergency authority in unusual market conditions, it is based on several years of experience and analysis. In 2004, the SEC adopted Regulation SHO to attack the problem of naked shorting. It requires broker-dealers, before they accept short sale orders or effectuate short sales in their own accounts, to first borrow the security to be shorted, or enter into a contract to borrow it.

But Regulation SHO also offers an alternative to these requirements if the broker has “reasonable grounds” to believe that the security can be borrowed. This could create opportunities for evasion of the rule’s purpose.

That has led the commission to consider simply eliminating the “reasonable grounds” alternative altogether. This is essentially what the SEC did for the financial firms for which the American taxpayer is now on the line. It is also what the commission is even now considering for the broader market.

We are also exploring other remedies to “distort and short” and naked short-selling abuses, such as the reporting of substantial short positions (akin to the long-standing requirement to disclose significant long positions). All of this comes on the heels of the agency’s recent elimination of other exceptions to Regulation SHO, and our March proposal of a new antifraud rule targeting naked short selling.

The SEC is committed to maintaining orderly securities markets. It neither can nor should direct the market’s fluctuations, up or down. Instead, the commission’s most basic role is to ensure a continued flow of liquidity to the markets from participants who are confident the game isn’t rigged against them.

Abusive naked short selling is far different from ordinary short selling, which is a healthy and necessary part of a free market. Manipulative naked short selling is one worry investors shouldn’t have.

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