As a result of what it called “a substantial threat of sudden and excessive fluctuations of securities prices and disruption of the functioning of the securities markets,” the Securities and Exchange Commission (SEC) introduced an emergency rule to curb short selling of stocks of several major financial firms on July 15 and later extended that order until Aug. 12. The rule restricted naked short selling of Freddie Mac, Fannie Mae and 17 investment banks. The SEC said it would “eliminate any possibility that naked short selling may contribute to the disruption of markets in these securities.”
Matt Paschke, manager of the Grizzly Short Fund and AdvantHedge Fund, says the overall effect of the rule has been fairly minimal. “They took a process that was already illegal and they said ‘this is illegal.’ It was really more PR and some would call it outright government manipulation of the markets,” he says. “For active short sellers, it hasn’t changed a whole lot. It creates a little more red tape and a little more of a process for those 19 names, but the majority of them, with the exception of Fannie and Freddie, you can still short pretty easily. And you can still short Fannie and Freddie, but you have to pay to short them now versus getting a rebate.”
The Managed Funds Association (MFA) and Coalition of Private Investment Companies (CPIC) sent a letter to SEC Chairman Christopher Cox saying the order could cause a loss of confidence in the price discovery function of capital markets and discourage legitimate short sales. In a statement, James S. Chanos, CPIC chairman and founder of Kynikos Associates, said “CPIC regrets the SEC’s continuation of the emergency order. We continue to believe that markets are best served when there is a level playing field between buyers and sellers, which in turn produces prices that have the greatest integrity.”
OneChicago saw increased interest from customers in single stock futures, especially in Fannie Mae, after the rule was introduced. Traders can sell security futures as easily as they can buy them. “Interestingly, we have been taking many calls from traders who are taking another look due to the new rules,” says OneChicago CEO David Downey, adding, “It still remains that the clearing members, ironically the very names that this ruling addresses, still resist letting the customers trade SSFs.”
Traders at CBOE weren’t greatly affected by the SEC order because of an exemption for options market makers and other types of market makers for the order’s borrow and arrangement-to-borrow requirement. “CBOE was pleased that the SEC was foresighted and took a close look at market makers’ function in the smooth operation of the options markets,” a CBOE spokesperson says.
If the SEC were to expand the emergency order to a broader list of stocks, the MFA and CPIC said that “market inefficiency, a reduction in liquidity and artificially created prices resulting from regulatory burdens on the normal price discovery process” would result.
Paschke thinks that the rule will be extended beyond August 12 and possibly expanded to include other financial firms. “It hinges on [whether] you believe the problems we’ve had [in the financial sector] are done or if you believe they’re getting worse.”
Paschke questions the apparent double standard of the government’s efforts in the equity and futures markets. “Why is no one talking about short selling oil? Everyone’s cool with taking long speculation out, but you don’t hear anybody talking about curbing short selling on the oil trade.”
