SEC new Short Sell Rule – the perfect compromise?

The SEC has been under tremendous pressure to ‘do something’ after all market turbulence and scandals. The old short sell rule, the so-called “uptick rule”, was introduced in 1938 and rescinded in 2007 by decree of the SEC. During the market panic of 2008, the SEC took what it called “emergency action” and temporarily banned investors from short-selling financial companies. Since then the necessity or harm of a short sell rule has been vigorously debated.

Under the new SEC Short Sell Rule from February 24, a circuit breaker will be imposed once the price of a security drops by 10% from the previous trading session’s closing price. Short selling is then prohibited for the rest of the trading session and the following trading session, unless the price exceeds the then current national best bid. Certain exemptions apply, but not for market making. The SEC vote on the new rule was split along party lines, 3 Democrats in favour and 2 Republicans against.

No one seems to be happy with the new rule. Critics of restrictions argue that short selling brings capital into the markets and helps them to more quickly discover accurate stock prices. Proponents for greater restrictions see a 10% fall as far too large and like to see a stricter uptick rule. Larry Tabb has written an excellent article on this here.

As no-one seems to be happy; maybe the SEC has found the perfect compromise. I think the largest problem with the new rule is the lack of an exemption for market making activity, which will hamper liquidity when it is most needed. That will hurt the small investor; the big guys can always find their way around the restriction using credit default swaps and other derivatives.

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