April 20, 2009
Short selling is a needed component in our markets and I don't think that point needs to be argued among professional investors. However, as with all things in a capitalist economy the capital will flow to the path of least resistance to generate returns. In that vain short selling is no exception.
There has been no end of stories and rumors of methods deployed by hedge funds to short sell and naked short sell securities. The greatest damage perpetrated in all this is the damage to shareholder confidence. Our system only works as long as investors believe it is fair and balanced. It is obvious that there is growing sentiment that this is not the case with out public markets.
So,the question we should really be asking is how do we restore investor confidence? Any other approach only serves to obfuscate the truth. I believe that several measures are needed to restore investor confidence while still allowing for regular short trading.
First, we need to re-implement a version of the uptick rule. I understand that when we changed to a decimal system it made things more difficult to manage but without a system it is quite easy to pressure an already depressed stock price and greatly increase volatility. Erratic gyrations in the prices of stocks is one of the greatest deterrents to investment. Without stability corporate fundamentals become inconsequential and all that matters is which stock(s) has the momentum.
Second, for any short trade the borrowed shares need to be secured before the sell is allowed. No short sale should be allowed unless the shares are in hand. Further, no sale of a stock should be allowed unless ownership can be verified. Over the last few years there have been numerous rumors about financial institutions that would go to elaborate measures to create the appearance of stock ownership so they could sell stock without meeting the short sale guidelines. This needs to be investigated and there needs to be more than a hand slap penalty for violators.
Third, violation of the rules needs to mean something. There is an obvious concern among smaller investors that if you have enough money you can do whatever you want. This is an ongoing problem though and not a one time event. The SEC needs to let the capital markets and professional do their job but there has to be fairness for them to work.