Ever since it was taken away, the subject of the uptick rule has been central in many debates. Most feel that the rule should never have been removed, and many feel that it was the removal of the uptick rule that brought this nation into the financial crisis. The fact of the matter is that there are many factors involved in why the nation is where it is in financial terms, and while the uptick rule plays a role in that, it is not the sole reason for our current situation. Even Jim Cramer, spoke of the imminent removal of the rule when it was about to happen, and the implications of that change. The removal happened, we have now seen many problems, the question is what can be done?
While most agree that the uptick rule should be brought back, the real sticking point seems to be that bringing the rule back would still not be an overall solution. Simply stated, reinstating the uptick rule is only one of many steps that need to be considered.
The uptick rule dictated when a short sale could happen, but did nothing to deal with whether those trades were legal, or even legitimate. It is the illegal short trades that harm the market. The uptick rule was functionally little more than a "choke point" that slowed the illegal, as well as the legal short trades.
What is needed is a general overhaul that balances the playing field between short and long investors. There are legitimate short traders. That needs to be stated quite clearly, and needs to be considered in any regulations that are set with regard to the subject. Many investors look at the short side of the market with a level of disdain. The fact is that the short side seems unnatural to many, and most do not fully understand the importance of the short side of the market. The short side is a very necessary aspect of the market. Without the ability to short, many companies would have a much more difficult time getting financing. Convertible bonds are a staple in a companies ability to obtain the funds they need to operate. Holders of such bonds typically short the stock in order to lock in their rate, and virtually guarantee a profit on the transaction.
The removal of the uptick rule was less of a problem than the illegal activities that were transpiring on the short side. The theory of a short sale is that the shares sold short would be matched up with real shares that were borrowed for the purpose of the trade. This matching is integral in the process. In theory, if there are no shares available to match up, the short sale should not go through. It is when short sales remain unmatched that we see real problems begin. This in effect floods the market with shares that do not even exist, thereby devaluing the equity further, and making a short position even more profitable, thus giving artificial strength to the short trade.
So what actions are needed in addition to the reinstatement of the uptick rule that will level the playing field? There are several things, but I want to focus on an exiting regulation that desperately needs updating:
PUT TEETH INTO THE REGSHO LIST
Before discussing this, it is important to understand what the REGSHO list is:
REGSHO is an SEC regulation that was adopted in 2005. The theory was that the REGSHO list would act to restrict naked short selling. As discussed above, naked short selling involves the selling shares which one has neither borrowed nor made arrangements to borrow. The regulation requires these brokers and short sale buyers to abide by a "locate" requirement and a "close-out" requirement. The locate requirement forces brokers to have reasonable grounds to believe that an equity security can be borrowed; the broker must document this prior to the security's sale. With some exceptions, the close-out requirement means that brokers who have failed to deliver a short-sold security for 13 days must purchase similar securities and present those instead. Brokers failing to do this may not engage in naked short selling until the position is closed. The rule also requires stock exchanges to publish daily a list of companies whose stock has failed to deliver over a certain threshold.
The theory behind the REGSHO list is pretty sound, but update is needed. With more and more happening on the Internet and through electronic means, the speed of transactions has far outpaced the existing language of the REGSHO requirement.
- The "Locate" Requirement - Because so much happens electronically, and we are technologically able to do far more in shorter time spans, the "locate" requirement should now be a "locate and commit" requirement. Make the broker "locate" the shares to borrow, and require both parties to tag those shares as "committed" to the transaction. The "locate and commit" requirement should happen prior to the transaction happening. If the broker is able to "locate and commit", notification should be forwarded electronically to the SEC.
- The Closeout Requirement - The thirteen days currently allowed to "close-out" is now a virtual eternity. There is no reason why share matching can not happen within 48 hours of the short sale. There is also no reason why documentation of every short sale can not be forwarded to the SEC by the broker. Because the broker will have already submitted a "locate and commit" notification to the SEC, they are now on a hunt to match that SEC notification with a "close-out" notification. If the SEC has the transactions of all short sales, they can enforce the regulation via unmatched "locate and commit" notifications with "close-out" notifications. Unmatched notifications clearly would identify the naked shorts for disciplinary and/or legal actions.
- The REGSHO List - This is the list that will show the "failures to deliver" (failure to match shares). In essence, if all short sales are reported to the SEC, any short position on an equity will become easier for the SEC to investigate. Instead of the SEC having to hunt down the perpetrators, they would already have all of the data they need to reign in the appropriate parties. Instead of disallowing short sales until the position is closed (which is a slap on the wrist), there should be a penalty associated with failure to comply. Companies that do not comply should automatically be banned from any participation in a short sale (even as a lender of shares) for a period of 10 trading days. By doing this, you force the brokerages to self police because the financial penalty is substantial, and the evidence would already be in the hands of the SEC. Licensed brokers as individuals should have a three strike rule where after the third strike, a license is suspended for 30 trading days. Brokerage houses should have a "three bad brokers" rule, where after three brokers hit strike three, the brokerage house will face fines and restrictions on trading activities.
- Removal From REGSHO List - Any equity that is unfortunate enough to find themselves on the REGSHO list made it there by illegal actions of others. Should a company make the REGSHO list, all shorting should immediately cease for automatically until the equity is off of the list, and then for 30 trading days after the equity is off of the list. In addition, fines to those that are "naked" should be established as three times the trading price of the equity adjusted daily. This type of penalty would force those that are out of compliance to get into compliance quickly and force them to buy the equity on the open market thereby helping to reverse a false downturn in the equity price. This enables an equity to at least have a chance of getting to a "real" trading level free of influence of illegal activities. The exception would be opening of a short position in dealing with the issuance of convertible bonds (a "natural" short position) if the company requests that type of relief.
I realize that much of what I have written is unlikely to happen and even has it's own flaws. After all, we are dealing with the Federal government and, as is oft the case, common sense goes out the window. The purpose here is to get investors to think a bit deeper about all of the issues at play, and this article dealt with only one of those (REGSHO). There is nothing wrong with a short side to the market. It is necessary and healthy. The issue is the illegal activities, good regulations, and enforcement. If we make the brokerages prove their short case before the trade, the regulators at the SEC can spend their time on real investigations instead of chasing their tales in miles of red tape.