Short Sellers See the Tables Turned as Stock Market Regulators Step In

September 19, 2008
by David Zimmer, Aaron Morgan Group
Commentary: Recent actions by stock market regulatory institutions on both sides of the Atlantic attempt to control the practice of short selling.

The U.K. Financial Services Authority put a temporary injunction on the short selling of finance sector stocks on Thursday, Sept. 18. The regulator said it might extend the ban to other sectors. The ban is set to remain in effect until Jan. 16, but it is due to be reviewed in 30 days, on Oct. 18.

Later the same day, the Securities and Exchange Commission took a decisive move to buffer the market by halting short selling through at least Oct. 2, after which date the order may be extended for anywhere from 10 to 30 days. Christopher Cox, the chair of the SEC, informed Congress of the regulatory board’s plan. Some market observers consider the ban disruptive of the market’s natural flow. Short selling is a legal practice of borrowing a security, then selling it in anticipation of a drop in price. The stock in question is then bought back, or “short-covered,” to make a profit from the price difference.

The SEC’s decision follows earlier steps it took toward temporarily restricting naked short selling, a type of short selling where the investor sells shares that he has not yet borrowed, but plans to. The SEC says naked short selling can allow investors to drive down market prices. Any trader who fails to provide the securities by the agreed-upon settlement date is subject to penalties under the new rules. Furthermore, a violation of this rule can lead to a broker being banned from making subsequent short sales.
These are significant steps, but are only part of what is happening. In addition to the actions taken by the regulatory authorities, a move by CalPERS, the California Public Employees’ Retirement System on Thursday highlights the potential effect for institutional investors to curb short sales. Many short sales occur only because institutional investors lend the shares, for a fee, to the short sellers. CalPERS announced it would temporarily cease lending the shares it held in four financial institutions: Goldman Sachs; Morgan Stanley; State Street; and Wachovia. Should institutional investors decide to “call in” the shares they have loaned, then short sellers would be forced to repurchase the shares borrowed in the open market.

The actions taken by both the British and American regulatory authorities, and CalPERS, will significantly impact short sellers and could cause a surge in the prices of stocks formerly restrained by both legal and illegal shorting.

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