How can short-selling restrictions be enforced?

The temporary ban on short-selling the shares of 799 US financial companies, announced on September 19, must be extended on Thursday, giving regulators and financial institutions a chance to consider how it has functioned in practice.

The US Securities and Exchange Commission (SEC) imposed the latest in a series of restrictions in response to recent alarming market volatility, following a similar decision by the UK’s Financial Services Authority (FSA). The argument of both is that short-sellers were engaging in market manipulation, especially of financial sector shares, without basing their decision on market fundamentals. Healthy banks were suffering as a result, they argued.

The FSA was acting according to type in moving first, in the face of (often harsh) investor criticism. Arguments adopted at the time against its restrictions -- that short-selling was a useful conduit of information about over-hyped firms, or often formed part of ‘market-neutral’ strategies in which one share was shorted while another was bought; that regulatory uncertainty caused the market to take fright – began to sound less convincing given the rapid deterioration of institutions’ financial positions in recent months. 

The debate over the need for further regulation has lessened -- but it remains unclear how the new restrictions will function in practice:

• Rules that force money managers to disclose their short positions may potentially improve market transparency by putting speculators off manipulating the market in secret. However, they are undermined by the option of delaying disclosure for two weeks -- designed to protect proprietary trading strategies, such a loophole makes it harder to tell in time whether market manipulation is taking place.

• Rules to make share buybacks easier will assist firms either directly (controlling prices by reducing the number of shares available to trade) and indirectly (demonstrating their financial health by showing they have the money to buy shares back). Equally, though, if a firm refuses to engage in a buyback, its vulnerability may actually be exposed.

• Attracting the most attention has been the ban on shorting a particular list of financial shares. Apart from criticism that the SEC lacked proof of manipulation of these particular institutions, the restrictions it put in place were attacked as simultaneously too restrictive (preventing legitimate market activity) and not restrictive enough (not preventing other forms of market manipulation – so that speculators flood to the remaining opportunities to express, and profit from, negative views of a firm). Furthermore, since the ban was only temporary, the risk remains that speculation will resume once restrictions are lifted.

As proof of the principle that speculator ingenuity evolves quicker than regulatory action, the dollar has been vulnerable in recent days to shorting, in a market where controlling the practice is notably more difficult.

The capacity of investors to evade any one set of regulations has shifted debate from what the SEC ought to do, to how it ought to behave. The SEC has cycled in the past decade between more or less investor-friendly officials. The administration of president George Bush has twice sought to steer the organization in a more free-market direction. The first attempt, under Harvey Pitt, attempted among other things to streamline accounting practices. Pitt stood down after the Enron accounting crisis in 2001. The second attempt, under Christopher Cox, concentrated on a lighter-touch approach to regulating financial markets. Cox is now under pressure for decisions including the abolition of the ‘uptick’ rule, dating from 1938, which prevented speculators from establishing a short position at a price lower than a target firm’s last trading price.

Pitt’s departure prompted the reign of William Donaldson, a strong regulator who stringently applied the Sarbanes-Oxley accounting rules, it seems likely that the organization’s latest missteps would encourage the appointment of another regulatory hardliner.

That assumes, however, that the organization will persist in its current form. With many of the investment institutions that the SEC exists to regulate going bankrupt or mutating into regular banks, and with the US Treasury and Federal Reserve leading the regulatory response to the current crisis, the SEC may emerge as a much-diminished organization when the dust in the financial markets finally settles.