The SEC vs efficient markets

The SEC is proposing to protect investors from accurate share prices.

Here’s today’s WSJ on the short-sale proposals and yesterday’s hearing. The bottom line is that Mary Schapiro has decided that her first action as SEC Chair should be to strike out against one of the key forces keeping markets honest. As James Chanos right said yesterday, "[p]roposals to inhibit short selling have the effect of limiting [a] vital market-based antidote to corporate fraud and speculative bubbles."

In brief, the proposals would generally restrict short-selling when stocks are dropping (the uptick rule) or are below the last national best bid, or provide circuit breakers when a stock is down more than 10%.

Professor Bainbridge has a more detailed summary. He rightly pans Schapiro’s arguments in support of the rule – anti-manipulation and that “unrestricted short selling can exacerbate a declining market in a security.” He notes that we already have rules against manipulation and that a ban on short-selling reduces market efficiency.

I have posted many times on that last point, e.g., most recently, here. But I’m not sure proponents of restrictions even care about these arguments. They don’t like short-selling because it tells the truth. As I commented about short-selling and Geithner’s shell game with troubled assets, "it's not surprising we don’t like the market’s negative verdict on the state of the world. Also not surprising that the government is tempted to build a fantasy world to escape from the verdict." And here: 

the securities markets are a report card on government actions. These actions, as I've said, are undermining and destabilizing markets by, among other things, dithering and threatening property rights. So it's not surprising that Barney Frank -- a key architect of the housing bubble that got us into the mess -- would like the naysayers to go away.

The SEC is clearly reacting to political pressure (see post just quoted and here). It should stick to its mission of protecting efficient markets rather than undermining them.

Comments

[C.E. Petit]

I'm sort of in the middle on this, but I'm unable to express a theoretical justification for being in the middle.

On the one hand, I recognize that short selling is valuable (I have done it with glee, such as in July 1987).

On the other hand, I'm not in favor of turning what is supposed to be a market into a casino, which is what happens when short (or, for that matter, margin) interest gets "too high" for some value of "too high."

So is a better solution not to regulate short selling per se, but the leverage, so that the externality of failure to cover gets limited? For example, under current rules for shorting a financial future -- and since financial futures dwarf the size of the equity markets, I think it's valid to look there -- require only 10% cash, making it a 10:1 "bet." The key distinction with equities is that direct leverage of this nature works more heavily on the short side of margin requirements. If one limits the leverage, instead of the actual transaction, does that operate as a sensible bubble-preventer? Or am I expecting too much by using "sensible" regarding unbalanced-participant markets?

[Ed]

I disagree with you on this one, Larry. The necessity for bringing back the uptick rule (or something like it) is not because of short selling per se. We need the uptick rule because it provides an (admittedly imperfect) mechanism to make market manipulation more difficult. Specifically, the uptick rule is one of the only ways to put a brake on naked short sellers. (We can discount 'fear of SEC enforcement' as counterweight; recent SEC Inspector General and GAO reports have shown how little the SEC has done to pursue naked short sellers.) I acknowledge that for many companies with very robust securities trading, naked short selling generally isn't an issue (save for the rare case of a company like Lehman Brothers, where there are some indications that naked short selling served as a catalyst for bankruptcy). But for the vast majority of issuers, with thinly traded stocks, no/little analyst coverage, and no/little interest from institutional investors, the securities of those issuers are not "efficient." They are instead very susceptible to market manipulation by aggressive short sellers. Those issuers need some sort of market protections (like the speed-bumps provided by an uptick rule or a 'circuit breaker') to make manipulation more difficult. We had the uptick rule for decades (though it unfortunately wasn't even extended to all securities trading) and short sellers seemed to do just fine. I suspect they'll continue to do just fine if we bring it back.

[MDF]

Ed, naked shortselling and the uptick rule are two entirely different issues. How does an uptick rule prevent naked shortselling? You just sell shares you haven't borrowed on the uptick.

It's pretty clear from the SEC's hearing last week that few if any of the commissioners think the uptick rule is a good idea. They just think it's not terribly harmful, given that it's so easy to get around, and letting Congress do something instead would be much much worse.