Wednesday, March 25, 2009

U.S. Exchanges Propose Rule to Restrict Short Selling (Update3)

By Edgar Ortega

March 24 (Bloomberg) -- NYSE Euronext, Nasdaq OMX Group Inc. and Bats Exchange Inc. proposed restraining bearish bets in stocks that have posted “precipitous” declines.

The largest U.S. equity exchanges offered to allow short sales only at prices that exceed the current best bid, according to a letter they sent the Securities and Exchange Commission. The so-called modified uptick rule would apply to stocks that have fallen a certain amount, such as 10 percent, they said.

The SEC will meet April 8 to discuss reinstating the uptick rule, which barred investors from betting against a stock until it sold at a higher price than the preceding trade. The exchanges are weighing in as lawmakers pressure the SEC to bolster markets roiled by the worst financial crisis since the Great Depression.

“When they see half-baked policy initiatives coming out of Washington, I don’t blame them for being proactive and saying, ‘Let’s try it this way,” James Angel, a finance professor at Georgetown University, said in an interview today. “They can read the political tea leaves.”

S&P 500 Drop

The Standard & Poor’s 500 Index has tumbled 46 percent since July 6, 2007, when the SEC eliminated the rule, erasing about $6.48 trillion in market value. In a short sale, traders sell borrowed shares, betting they’ll be able to repay the loan by purchasing the stock at a lower price and pocketing the difference as profit.

Senators Ted Kaufman, a Delaware Democrat, and Johnny Isakson, a Georgia Republican, proposed bringing back the uptick rule and imposing tougher restrictions on the short sales of financial companies. Representative Gary Ackerman, a New York Democrat, has tried to press the SEC to reinstate the rule since at least July.

The exchange proposal marks an agreement among the largest U.S. equity markets on how to curb short sales. While NYSE Euronext Chief Executive Officer Duncan Niederauer has proposed reviving the restriction since September, the heads of Nasdaq and Bats had preferred restraints only on stocks that suffered large decreases. The National Stock Exchange, based in Jersey City, New Jersey, also signed the letter to the SEC.

John Nester, a spokesman for the SEC, said the agency “looks forward” to reviewing the recommendation. Chairman Mary Schapiro told Congress in January that she was committed to reviewing the uptick rule.

‘Modest Positive’

“It’s long overdue,” said Tim Ghriskey, who helps oversee $2 billion including an investment strategy that uses short sales at Solaris Asset Management in Bedford Hills, New York. “The uptick rule does make it harder to sell short, and the reinstatement of the rule will give the stock market a modest positive bias.”

The original regulation, which dates back to 1938, required short sellers to wait for completed trades at a higher price, instead of focusing on current bids as the exchanges’ proposal today does. The plan would apply to stocks traded on all exchanges, and not just NYSE-listed stocks as the original rule.

“This is something that we, along with the other exchanges, feel is not only a viable solution, but a solution that we’ll be able to implement rather quickly,” Bruce Aust, Nasdaq executive vice president for listings, said in an interview today.

The SEC eliminated the provision after a study in 2007 determined that it was no longer relevant in markets dominated by fast-paced electronic trading with stocks gyrating in penny increments. Some traders said resurrecting the rule would do little to curb short sales.

Penny Increments

“It may alleviate some of the downward pressure during extreme times,” said John O’Donoghue, co-head of trading at Cowen & Co. in New York. “But quite frankly, the fact that we trade in pennies has made the uptick rule somewhat redundant.”

SEC economists Daniel Aromi and Cecilia Caglio concluded in a December study that a test similar to the one proposed by the exchanges was less effective when needed most, during panics that drive down stock prices and increase volatility. The rule would be most restrictive on short sellers during times when prices were little changed, according to the December study.

The exchange said their proposal would allow for unfettered trading if stocks are rising or little changed, as well as make it cheaper to implement. “It avoids imposing continuous monitoring and compliance costs where there is little or no corresponding risk of abusive short selling,” the exchanges said in the letter.

Original Form

Ed Laux, head of equity trading at Cantor Fitzgerald LP in New York, said the plan doesn’t go far enough in curbing short sales.

“If you’re going to have it back, you should have it back like it was beforehand,” Laux said in an interview. A 5 percent threshold “might stand more of a chance” of working, he said.

Regulators from Washington to London last year cracked down on short selling. In the U.K., a Financial Services Authority prohibition on shorting 34 financial companies expired in January. The SEC eliminated a similar measure Oct. 9 after exchange data showed the prohibition fueled volatility and made it more costly to trade.

“The uptick rule would be an easy fix that would give the appearance that Washington is doing something about it,” said Kevin Kruszenski, director of equity trading at Keybanc Capital Markets in Cleveland. “There’s a lot of political pressure to bring this back.”