The Securities and Exchange Commission is contemplating moving forward with new rules to curb short selling, but a new study commissioned by the hedge fund industry's chief lobbying group says some of those rules could make trading more expensive.

At a presentation before the Practising Law Institute on Feb. 5., SEC Chairman Mary Schapiro said the agency is close to finalizing rules on short selling.

Short sales were blamed for contributing to the downfall of Bear Stearns Cos. and Lehman Brothers Holdings Inc., and last year the SEC adopted rules aimed at reducing "naked" short sales. Traditional short selling, in which a speculator borrows shares and sells them in hopes that a price drop will allow the position to be covered profitably when it's time to return the borrowed shares, is considered a legitimate practice. Naked short selling, in which shares are never borrowed, is considered disreputable because it allows speculators to relentlessly put downward pressure on a stock without ever putting capital at risk.

"These rules have significantly reduced the number of times short sellers failed to deliver securities," Schapiro said.

Now among the most contentious of the proposals under debate is whether short sellers should be required to publicly disclose which stocks they are betting against. "In the coming weeks we will consider proposals to [further] restrict the practice of short selling," Schapiro said.

The idea isn't going over well with some investors. A study released earlier this month by consulting group Oliver Wyman and commissioned by the Managed Funds Association concluded that short-selling disclosures could discourage legitimate short selling, a valuable practice that adds liquidity to markets and dampens inflated stock prices. If disclosure requirements are too frequent or are at thresholds that discourage short selling, the resulting "withdrawal of liquidity would have detrimental impacts on equity markets," the MFA said.

The study examined trading activity in dozens of stocks currently subject to short-sale disclosure rules in Britain. The report showed that public disclosure of short positions had several unintended consequences, including a widening of bid-ask spreads by more than 45% in the stocks covered by the disclosure rules. Richard Baker, the MFA president, says the study "demonstrates that recently adopted public disclosure rules in the U.K. have impeded equity market liquidity, decreased trading volumes and interfered with efficient price discovery in affected stocks, driving up transaction costs for mainstream investors and burdening businesses with a higher cost of capital."

The report also found that total trading volume in British stocks subject to the short-sale disclosure rules -- including long trades -- decreased by 13% during the disclosure period. In addition, the British disclosure rules resulted in a decrease of 20% to 25% in short sellers' participation in equity markets.

"Investors find the information they are required to disclose to be sufficiently sensitive that they limit their activities to avoid making disclosures," according to the report.

The MFA says this may be remedied by allowing investors to report short positions confidentially to regulators. "Private reporting would allow regulators to identify and investigate any abusive short-selling activity while avoiding the unintended negative consequences for markets and investors," Baker said.

Alternatively, industry insiders say that disclosures made on a quarterly basis along the same lines of those made for long positions might also make sense but that positions shouldn't be disclosed on an immediate or daily schedule. They claim it could have the perverse effect of allowing retail investors to follow the moves of hedge funds that specialize in shorting. Daily disclosures of short positions could also affect short sellers' competitive advantage by forcing them to reveal their trading strategies.

Other issues being considered are marketwide curbs and circuit breakers that would restrict short selling if a stock fell by a certain percent, and a modified version of the uptick rule, which prevents investors from selling a stock short after it has fallen by a predetermined percent -- unlike regulations that were disbanded in 2007 -- until after it rose -- or ticked up higher.

Donna Block covers the Securities and Exchange Commission for The Deal.

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