Safe short-selling regimes unveiled

Two new proposals have been published aimed at creating a safe framework for conducting short-selling in the equity markets.
By None

Two new proposals have been published aimed at creating a safe framework for conducting short-selling in the equity markets.

Three leading US exchanges have recommended the adoption of a “modified uptick rule” to the US Securities and Exchanges Commission (SEC), while the International Organization of Securities Commissions (IOSCO) has outlined four principles to help develop “a more consistent international approach for the regulation of short-selling”.

As financial stocks tumbled under severe selling pressure in the second half of last year, many national regulators imposed either outright bans or restrictions on short-selling.

NYSE Euronext, Nasdaq OMX and BATS Trading, the three biggest exchanges in the US, have written to the SEC’s new chairman, Mary Schapiro, to propose a new version of the uptick rule that previously only permitted short-selling when the last sale was at or above the previous sale. This prohibition of short-selling in a falling market is still used in a number of countries, including Hong Kong, which made no changes to its short-selling regime last year.

The three exchanges argued that a reintroduction of the original uptick rule would be difficult to enforce in a penny increment market structure and less effective than previously due to increases in modern-day trading speeds and volumes. Instead, they suggested a new rule which only permits a short sale at “a higher price that the prevailing market at the time of initiation, and only on a passive basis”. NYSE, Nasdaq and BATS asserted that the restriction would prevent manipulative short-selling, dampen downward price pressure and be easier to implement into surveillance systems than the previous uptick rule.

The exchanges recommended that the modified uptick rule be used in combination with a circuit breaker that would trigger its use only after the price of a stock had “experienced a precipitous decline” in the region of 10%. They pointed out that a circuit breaker mechanism would permit normal market activity while a stock was trading in its natural range, but restrict short-selling in the event of sharp decline, as it is in these circumstances that short-selling can become “abusive and harmful”.

The IOSCO’s recommendations, issued for consultation until 4 May, are designed to eliminate gaps between the existing approaches of regulators to naked short-selling – i.e. selling a stock short without borrowing it – without restricting legitimate trading activities.

According to IOSCO’s technical committee, regulators’ short-selling must include: controls that minimise risks that could affect stability of financial markets; reporting of timely information to market authorities; an effective compliance and enforcement system; and exceptions for “certain types of transactions for efficient market functioning and development”. IOSCO suggested that strict settlement of failed trades, such as a compulsory buy-in mechanism, should be regarded as a minimum requirement.