Short Selling and ‘Regulation SHO’ | Policy Memo

Disclaimer: I am not, nor do I claim to be an investment expert. This policy memo is specifically to explore SEC short selling regulation. I am not providing investment advice or guidance.

INTRODUCTION

In light of the current tumultuous economic trend involving a so-called trading frenzy between retail or amateur investors and largescale hedge funds, I thought it would be prudent to jump into the regulation that governs short selling and which will most likely preside over the current fight over the stocks of GameStop and other companies struggling through the pandemic.

The word is that big time hedgefund managers put in numerous short sale orders and that small-time investors have banded together en masse to continue to elevate the price of the stocks, much to the chagrin – I’m sure – of those who placed heavy bets that the opposite would follow.

Now, those same large scale investors are having to cover their losses and experts are being are being called to explain what many on a subreddit called r/WallStreetBets are seeing as a threat by hedgefunds to trigger a fear-based selloff in novice investors and day traders.

BACKGROUND

But what is a short sell, and if it is so toxic an act to the economy, why is it legal?

Short selling is essentially when an investor places a “bet” or order on a set of stocks – borrowed or purchased specifically with the intent to sell – with the belief that these will markedly drop in price within a given time frame. The investor is then able to buy those securities back at a significantly cheaper value, making a profit later.

These can potentially trigger massive selloffs, however short sales are also a way to maintain consumer faith in markets during periods of volatility, possibly as a means to say the markets are still actionable even during corrections, and so short selling remains legal.

However, that does not mean there are not rules, and that is where the Securities and Exchange Commission comes in.

The ‘Regulation Sho’

The U.S. Securities and Exchange Commission holds numerous current regulations that restrict and oversee the process of short-selling as a means of preventing abuse and keeping the market stable in the event that a particular stock or set of stocks drops by 10% in market value in one day.

The particular set of regulations I want to discuss here are collectively called ‘Regulation SHO’, which is a detailed set of regulations that essentially boil down to four primary sections:

(1) Trades are required to be marked as long, short, or ‘short-exempt’ by one’s broker;

(2) trading centers are required to maintain a set of comprehensive policies and standard operating procedures designed to prevent or to trigger a “circuit-breaker” which prevents a price decline of more than 10% in a stock in one day; once this trigger is engaged, a “price test” will be applied only to short sales for the remainder of the day;

(3) a broker must have reasonable belief that a security can be borrowed or “located” so that it may be later delivered according to the terms of a short sale, which may not be executed until securities have been located;

(4) if there is a failure to locate, then short sales may not resume until the broker has located securities matching in kind and in quantity to the needed securities; if the failure to locate can be proven to have been tied to a long-sale, then securities to fulfill the sale must be found within three-business days of the receipt of the sale.

conclusion

It is important to note that short selling has always been seen as a potential sight for abuse, leading to the first SEC regulation upon them all the way back in 1937. The regulations set in place to address any potential fallout caused by collective short selling are put in place not only to prevent any abuses and breaches of law but – primarily it would seem – to ensure market stability even during periods of natural correction.

From runaway sell-offs to companies using rapid short-selling schemes in order to under cut competition, SEC’s Regulation SHO is written to oversee the day-to-day operations of trading centers and stock brokers, and to ensure adherence to those rules which allow for safe and continued orders of short sales.

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