Since the stock market crash in 1929and the ensuing Great Depression, short selling has been the scapegoat in many market downturns. In a short sale, an investor sells shares in the market, which are borrowed and delivered at settlement.
The intent is to profit by buying shares at a lower price to repay the loaned shares. After the Great Depression, the U.S. Securities and Exchange Commission (SEC) limited short-sale transactions to mitigate excessive downside pressure.
While short selling has been blamed for market crashes and labeled as unethical by some critics because it is a bet against positive growth, many economists and financial practitioners now recognize short selling as a key component of a well-functioning and efficient market, providing liquidity to buyers and promoting a greater degree of price discovery.
Still, exchanges and regulators have put certain restrictions in place to limit or ban short selling from time to time. Here, we take a look at some of these measures.
Key Takeaways
- Selling short involves selling borrowed shares in order to buy them back at a lower price, essentially profiting from a bearish bet.
- Short selling has been blamed for market crashes and has been temporarily banned several times in the past around the world.
- The U.S. has restricted short selling at times to increase transparency and restore investor confidence.
- In-depth empirical research, however, reveals that short selling can boost efficiency and provide information to the markets.
A Brief History of Banning Shorts
Throughout history, regulators and legislators have banned short selling, either temporarily or more permanently, in order to restore investor confidence or to stabilize falling markets under the belief that selling short either triggered a crisis or made it worse.
For instance, in the early 1600s, the newly created Amsterdam Stock Exchange temporarily banned short selling after a prominent short seller was accused of manipulating prices in the stock of the Dutch East India Company. Likewise, the British government banned shorts following the fallout from theSouth Sea bubbleof 1720.
More recently, at the height of the 2008financial crisis, temporary short-selling bans and restrictions were seen in the U.S., Britain, France, Germany, Switzerland, Ireland, Canada, and others.
Many governments over the years have taken actions to limit or regulate short selling, due to its connection with a number of stock market selloffs and other financial crises. However, outright bans have usually been repealed, as short selling is a significant part of daily market trading.
The Uptick Rule
For many years after its enactment in 1938, the uptick rule prevailed in the U.S. This rule was put in place following the Great Depression and allowed short selling to only take place on an uptick from the stock's most recent previous sale. For example, if the last trade was at $17.86, a short sale could be executed if the next bid price was at least $17.87. Essentially, this rule does not allow for excessive sales pressure from short-sellers, and it helps keep the market in balance, at least in theory.
Several studies have been performed over the years, revealing that no additional relief comes from the uptick rule in a bear market. In 2007, the SEC repealed the uptick rule, giving free rein to short-sellers who soon took advantage in the next stock market crash in 2008. The SEC has since revised the rule again, imposing the uptick rule on certain stocks when the price drops more than 10% from the previous day's close.
The 2010alternative uptick rule, known as Rule 201, allows investors to exit long positions before short selling occurs. The rule is triggered when a stock price falls at least 10% in one day.At that point, short selling is permitted if the price is above the current best bid.This aims to preserve investorconfidence and promote market stability during periods of extreme stress and volatility.
Regulation SHO and Naked Shorts
An essential rule for short selling involves the availability of the stock to be sold. It must be readily accessible by the broker-dealer for delivery at settlement;otherwise, it is a failed delivery or a nakedshort sale. Though in a stock trade, this is deemed a renege, there are ways to accomplish the same position through the sale of options contracts or futures.
Regulation SHO is a rule implemented by the SEC in 2005 to update rules concerningshort-sale practices. Regulation SHO established "locate" and "close-out" standards that are primarily aimed at preventing the opportunity for traders to engage in naked short selling and other unethical practices.
The "locate" standard requires that abrokerhas a reasonable belief that the equity to be short sold can be borrowed and delivered to a short selleron a specific date before short selling can occur. The "close-out" standard mandates that investors close their short sale during a certain period of time in the case of a failure to deliver.
SEC Reporting Requirements
In an effort to enhance market transparency and protect investors, the SEC instituted new rules in 2023 concerning the reporting of short-selling activities. This modification arrived in a climate of heightened scrutiny around short selling, especially following the "meme stock" craze, where retail investors significantly drove up the price of GameStop stock, inflicting severe losses on hedge funds that had shorted the company. This saga accentuated the opaque nature of short selling and its potential to be employed in market manipulation.
Prior to the enactment of the new rules, the details surrounding short-selling activities largely remained in the shadows. Although the Financial Industry Regulatory Authority (FINRA) already publishes short interest reports collected from broker-dealers, this data was limited in scope. The SEC’s new regulations demand a more comprehensive disclosure. Specifically, institutional investors are now required to report their gross short positions to the SEC on a monthly basis. Moreover, certain "net" short activity for individual dates on which trades settle is also mandated to be reported. This new data will encompass daily net activity on each settlement, a type of data not previously available with FINRA or the exchanges.
The SEC intends to publish this collected data on a delayed basis, providing stock-specific data, which would allow for a fuller understanding of market-wide short bets. By doing so, both regulators and members of the public are better positioned to react to or prevent destabilizing market events, fostering a more robust and transparent financial ecosystem.
These rules not only represent an extension of the reporting requirements but also a shift toward a more transparent and accountable market. Critics argue that these rules could, however, expose investors' strategies, potentially harming market participants and market efficiency. Yet, proponents believe such disclosures are crucial for promoting fair market operation and curbing malicious practices associated with short selling.
What Is a Short Selling Example?
Imagine that Alex, a hypothetical investor, believes the stock price of Company XYZ, currently trading at $100 per share, is going to decline in the near future due to some upcoming negative earnings reports. Alex decides to short sell 100 shares of Company XYZ. First, Alex borrows these shares from his broker. Alex then sells them on the open market at the current price of $100 per share, receiving $10,000 ($100 per share x 100 shares). Over the next few weeks, as expected, Company XYZ releases unfavorable earnings reports, and its stock price declines to $80 per share. Seeing this price drop, Alex decides to close his short position by buying 100 shares of Company XYZ at the new price of $80 per share, spending $8,000 ($80 per share x 100 shares). Alex returns the 100 shares to the broker and nets a profit of $2,000 (less commissions and taxes) from this short-sale transaction.
The new rules signify the SEC’s proactive stance in adapting to market dynamics and addressing the concerns arising from the modern-day trading environment. By shedding light on the often murky waters of short selling, the SEC is aiming to foster a more transparent, accountable, and resilient market, ensuring that it remains a level playing field for all participants.
What Is the Objective of Short-Sale Regulations?
The primary objective behind regulating short selling is to promote market transparency, prevent market manipulation, and ensure a level playing field for all investors. By enforcing rules around disclosure and reporting, regulators aim to curb malicious practices and provide a clearer picture of market dynamics, which in turn helps to promote market integrity and investor confidence.
How Does Short Selling Contribute to Market Efficiency?
Short selling can contribute to market efficiency by facilitating price discovery and liquidity. When investors engage in short selling, they are essentially expressing a negative view of a stock's value, which can help correct overpriced securities and bring prices closer to their intrinsic value. Additionally, short selling increases the volume of trading, which can improve liquidity and make markets more responsive.
What Are the Penalties for Breaking Short-Sale Regulations?
Penalties for non-compliance with short-selling regulations can be severe and may include hefty fines, trading bans, and in severe cases, criminal charges. The exact penalties depend on the jurisdiction, the specific regulations, and the extent of the violation.
What Is Naked Short Selling?
Naked short selling, or naked shorting, is a controversial and, in the U.S., illegal trading practice where investors sell shares of stock they do not own and have not borrowed, essentially selling nonexistent shares. Naked short selling can contribute to market manipulation and fraud. By selling nonexistent shares, naked short sellers can artificially increase the supply of a stock, which can in turn depress its price. This can mislead other investors and distort the true market value of a stock.
The Bottom Line
Short selling has been found to actually increase market efficiency by providing liquidity and information necessary for price discovery. And some research has found that short-selling bans or regulations, like the uptick rule, can hinder pricing efficiency.
Indeed, short selling remains legal around much of the world today, and temporary bans or restrictions on shorting due to market turmoil have often been rescinded once those crises have abated.
