The SEC short selling ban covers 779 financial stocks until Oct. 2 and imposes new penalties for clearing brokers that fail to deliver on shares sold short after t+3. The FSA ban covers only 39 UK financial stocks but the window extends to January 16 of next year.
Overall the impact on market liquidity is expected to be significant. According to a report released last week by my friend Joe Gawronski at Rosenblatt Securities:
“Bans on shorting financial stocks, combined with the new disclosure and fail-to-deliver penalties, should exert considerable downward pressure on volumes. Short selling by hedge funds and other investment managers, as well as by many smaller and medium-sized high-frequency trading firms (but not their larger brethren), is likely to drop off significantly during the terms of the emergency orders.”
The options markets could be hit especially hard by this move. Options market makers have enjoyed an exemption from borrowing stocks before shorting intended to allow them flexibility as they offset their exposures. If they can’t borrow shares to deliver short then they can’t sell protection to the markets. On Friday it was reported that an SEC staff recommendation had been put forward to amend the order to allow options market makers to keep their exemption. The SEC’s waffling on this point is understandable since, with traders at bank desks sitting on their hands for want of capital, the locals are suddenly the only game in town. Without them, buyers and sellers will only be able to transact if they happen to meet in the same strike and maturity.
Decreased liquidity is obviously not the biggest negative aspect of this order. The natural checks and balances that legal short selling provide allows greater efficiency in the marketplace as short sellers are incentivized to police the market for poor performing management teams, corporate malfeasance and unrealistic valuations. By removing this force from the market we are sending a message to the world that our financial firms are too weak to stand on their own and that we will protect them despite by changing the rules of the game if need be. To some investors, this will look like the first step down a slippery slope of market manipulations that have chased foreign capital out of other markets in the past. Even if more banks failed without the short sale ban, there would remain faith in the integrity of the US market system. With this solution, we demonstrate that our market has no more integrity than our bad banks.