"New " Short Sale Rule

Even if you never pick up the business section of the paper, it has been hard not to notice that the stock market has been particularly volatile lately. Although there are numerous factors involved, most of the volatility has stemmed from the uncertainty surrounding the solvency of our nation's two largest mortgage lenders, Fannie Mae and Freddie Mac, as well as questions surrounding the balance sheets of some of the larger commercial and investment banks with large opaque mortgage portfolios like Wachovia, Washington Mutual, Merrill Lynch and Lehman Brothers.

Just as surely as blood in the water attracts sharks, volatility attracts short sellers. Yesterday the Securities and Exchange Commission announced an emergency order stating that they were going to crack down on naked short selling (i.e. selling shares you have not borrowed, nor have even a reasonable expectation of borrowing) in 19 of some of the most volatile and vulnerable financial stocks. Their plan will go into effect Monday.

Here are the highlights:

No person is permitted to short any of the 19 stocks on the SEC list without first securing one of the following:

1) Have a borrow in hand
2) Have a pre-arranged borrow
3) Have shares in inventory

• There’s culpability at the order entry level, not just the settlement level.
• Pre-borrows will have a fee attached.
• Delivery requirement does not permit any Failure(s) to Deliver (FTD), no penalty for non-compliance is mentioned though.
• Traditionally there has been a 13 day window before a mandatory buy in happens. All trades will have to settle in 3 days.
  
• Exercising a put option that results in a short position is covered by the new rule, auto-exercise of a put option is also covered.
• Assignment of options is not covered
• If you have a pre-borrow (not just a locate) the executing broker can take the short order.
• SEC will exempt market makers, specialists, etc…details not released yet.
• Slated to expire in 10 days but can be extended for 30 days.
• Documentation will be paramount.

It is difficult not to conclude that all of this is SEC political posturing in the face of market turmoil. Naked short selling is already illegal after all, just as it should be. The problem is that there is no enforcement. It seems that a few very heavy fines at the order entry level would go a long way towards stopping the practice since there's no incentive for prime brokers to police beyond their mandate that a short seller must have a "reasonable expectation" of being able to deliver a stock. In fact, there's a disincentive because they collect fees for facilitating a short sale--borrow or not.

The Depository Trust & Clearing Corporation (DTCC), where virtually all stocks go to settle, has in place a system called the continuous net settlement (CNS) system. To oversimplify what it does, each prime broker "nets" out their positions each night which acts to cut down on a lot of back office noise and electronic paper shuffling. If a prime broker acting on behalf of a client fails to deliver a stock because the client did not secure a borrow before selling the stock short, it throws the system out of balance. If this is not rectified over the normal settlement period of 3 days, the stock transaction may be flagged FTD (failure to deliver). After 13 days, the position will theoretically go through a "buy in" where the prime broker goes into the open market and purchases the stock in order to make good on the delivery to the counter party. Since markets are dynamic, the price paid in the open market for the buy in can vary greatly from the reported price on the original transaction, and let's not even consider that the stock you buy in could result in another FTD. To say the least the potential for an ugly and costly situation exists when a FTD is issued. One way to avoid this potentially nasty situation is if all prime brokers on the CNS system collude to not issue FTDs unless under the direst of situations. That is exactly what they do. The whole system is a house of cards supported only by the fact that nobody calls in their chips.

I have to give some credit to the SEC. They're an overworked and under-funded department charged with maintaining the integrity of our markets against the malfeasance of some of the most intelligent, clever and greediest people on the planet.

The SEC did well when they eliminated the plus tick rule. Now it is imperative that they extend these naked short rules to the market as a whole and then actually enforce them. The electronic paper trail is not difficult to follow, and if the chances of getting caught go from close to zero (as they are now) to close to 100%, you'll see the practice stop virtually overnight. Nothing hurts a trader more than getting kicked right square in the pocket book.

Short sellers provide a vital service to financial markets. They are often the first to point out that the "emperor has no clothes" and they provide another source of liquidity when markets get overheated. But the artificial conditions created when one engages in naked short selling needs to be stopped.