Short-selling is one of those practices that embody the financial economy. And the rules and regulations that shape short-selling tell us a lot about our tolerance toward that sector. To outsiders, short-selling is nearly always viewed with suspicion. After all, markets exist to go up (well, not really, but that's the general view) and shorts are subversive downers. You have wide latitude to talk a stock up because, after all, optimism and bullishness are built into the system; but to talk a stock down is to threaten the very underpinnings, to question the optimism that makes it fly. Truth in these cases has nothing to do with anything. In the midst of the meltdown in the fall, shorting was just about the only strategy that made sense. And yet even CEOs of battered Wall Street firms -- perhaps the greatest short sellers on earth -- clambered onto the bandwagon to demand a moratorium on the practice. Politicians and regulators followed.
Now the SEC has promulgated a series of new rules that provide more disclosure and limitations on shorting. On the always-incendiary issue of naked shorting, the SEC will demand that actual borrowed shares must be in hand within four days following the trade, or fines will follow. Most of the rest of the new requirements involve posting anonymous trading information a month later. Not surprisingly, the hedge funds, which finally seem to be getting their mojo back, lobbied against the changes.
In reality, these rule changes are pretty superficial. The naked shorting rules may have real bite (and it is an abuse, though whether it's a systemic threat is debatable), if the SEC investigates and pursues violators. This isn't an issue for the next few years -- the agency will probably be on top of this -- but for years ahead, when regulatory memories have faded and markets are rising like topsy. As for the disclosure matter, hedge funds complain that proprietary trading strategies can be reverse engineered from the month-old trading data. How much of a problem is this? First, if it were a shorting strategy, wouldn't you want downward pressure on the stock? Second, that month-old data wouldn't affect your use of shorting as a hedging tool. Third, in this environment, the argument that your speculative shorting strategy can be imitated is a bigger nonstarter than reviving the presidential ambitions of, say, Alan Keyes.
The truth here is that the SEC realizes the markets need a certain amount of shorting to keep everyone honest. Shorting is like free trade: The more you know, the more you realize its importance. You can easily overstate this, but the truth is the shorts were one of the few bulwarks against a bubble mentality, but because the bull market went on for so long, their resistance flagged. The last few years of the bubble may have been the worst: There were more and more obvious targets, but markets kept rising anyway. Short-selling among the political crowd resembles fair value accounting: Take it away and everything will be good again. This kind of manipulation from Congress' cheap seats is exactly the kind of intervention that a band of global regulators recently warned about (see Floyd Norris' story in Tuesday's New York Times) and exactly why thrusting the Federal Reserve into a political role is so perilous. With the shorting issue, Mary Schapiro's SEC has shown a deft touch, by noisily announcing some reforms, without killing the useful underlying practice. And, again, the deft use of rules can serve to protect an unpopular, if necessary, practice.
Lastly, the emergence of shorting as an issue brings up one of the craziest regulatory jihads of recent memory: the SEC's anti-rumor crusade during the crisis last fall. Rumors and shorting go together like peanut butter and jelly. Stocks getting shorted always seemed wrapped in a miasma of truth, half-truth and rumor. (Which raises the philosophical question: When does a partial truth become a rumor?) Not that that's particularly unusual: Every data point in the market, particularly at the speculative end, toggles precariously between truth and nontruth. The Christopher Cox SEC's campaign against rumormongers was fated to fail (or to engage in a witch-hunt, an appropriate metaphor given the pursuit of ghostly half-truths) and all-but guaranteed to send truth-seeking regulators into a hellish hall of mirrors. Schapiro's SEC did not touch the rumor issue, but purely for entertainment's sake the agency should write up a final report on how it went. - Robert Teitelman
See related story from The New York Times
Robert Teitelman is the editor in chief of The Deal.
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"Stock Shock" is a movie that explains how the whole naked short selling thing works--and how NSS nearly took us into a second Depression. This movie is worth the DVD price if you are an investor. Amazon has it or stockshockmovie.com
Investors losing money and frustrated with the SEC inaction sent copies of the new movie: "Stock Shock" to their offices and demanded action.