A Shot in the Dark

Story Highlights:

• The SEC responded to recent market volatility by imposing on Thursday three trading rules targeting short selling.
• Not to be outdone, Britain's Financial Services Authority mandated a ban on all further short selling in financials and implemented new disclosure requirements.
• Yet, curtailing short selling is at best a regulatory shot in the dark.
• Most frightening is these new rules have come at a rush—and knee-jerk regulatory reactions are often prone to negative, unintended consequences.

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The inevitable blame game arising from perceived market failings has doomed short sellers to the chopping block—at least temporarily. In brash fashion, the SEC responded to recent market volatility by imposing on Thursday three trading rules targeting short selling. Most notably, the new rules essentially institute a ban on "naked" short selling and tighten requirements for option market traders. Strict penalties apply for breaching the rules. In addition, the SEC is expanding its push into the trading records of hedge funds, even as various institutions and regulators are pushing for the SEC to take its authority yet further.

Not to be outdone, Britain's Financial Services Authority (FSA) mandated a ban on all further short selling in financials—naked or regular. And in what will likely amount to the death of a small forest in new paperwork, the FSA will soon require daily disclosures of all net short positions that surpass specified levels.

Although the British ban is temporary (expiring January 16, 2009), the recent moves against short selling on both sides of the Atlantic highlight the new fever pitch in today's financial woes. The volatile market reactions to Lehman, AIG, et al, have stunned investors, CEOs, and regulators alike—leaving many scrambling to find the cause. The finger-pointing is in full effect already.

Today, the finger lands on short selling. Yet, curtailing short selling is at best a regulatory shot in the dark. Overwhelmingly, short selling activity is not conspiratorial. It is a legitimate investing technique that aids markets in seeking appropriate prices for assets, among other good. Wiping out the tool likely hurts more legitimate investors than punishes malicious ones.

Particularly concerning is these new rules have come at a rush—and knee-jerk regulatory reactions are often prone to negative, unintended consequences. It's seldom wise to suddenly change rules in the middle of the game. Ultimately, such changes create dislocations causing unexpected parties to get inadvertently penalized. Just ask the big custody banks that do securities lending—some of whose stocks declined more than 50% briefly intraday Thursday only to recover near breakeven by the close.

Overall, we see little benefit from these changes and plenty of potential trouble. Months ago when oil prices persistently marched upwards, regulators accused speculators of manipulating markets. But now, with oil prices down around $100 without speculation regulation, those accusers are largely silent. Perhaps they were just saving their breaths for the short sellers.