SEC Short Sales Ban Did More Harm Than Good

On September 19, the United States Securities and Exchange Commission (SEC) abruptly banned short sales of financial stocks to protect companies that had come under siege in the stock market. There have been concerns that short sales are behind the big price slides in the market. Many felt that short sellers had contributed to the declines by betting against the companies’ shares. The SEC also came out with a new set of disclosure rules for short sellers. The SEC lifted the ban last week, and short sellers were allowed back on Wall Street from October 9.

Some analysts argue that short-selling can be used to manipulate share prices and add to pressure on fragile companies. Others say it is a legitimate tool that helps markets function.

The ban originally applied to 799 companies, but the SEC allowed the stock exchanges to add other companies to the list. Before the ban was lifted, about 190 more had been added, including General Electric, General Motors, and CVS Caremark.

In a short sale, investors borrow shares and immediately sell them, hoping to profit by replacing them later at a lower price – a sell-high, buy-low strategy. Short sellers seek to profit from a stock’s decline by selling borrowed shares and replacing them at a lower price. During the ban, borrowing shares has become more expensive, in part because some big pension funds and endowments have stopped lending stock altogether.

Hedge funds were badly affected by the ban and blamed the new rules for pushing them deep into the red. Many trading strategies rely on short-selling, and investors may have sold off some of their long positions in the market, driving prices down, because they were not able to hedge their bets with a corresponding short position. Convertible bonds were also adversely affected because traders typically short a company’s stock when they invest in its preferred shares. The raw number of trades in financial stocks also dropped, as many investors simply sat on the sidelines.

It now appears that the ban probably did not do what it was supposed to do. Since the ban, financial shares have plunged 23%. The market plunge following the ban has started a debate on whether the ban actually worked and whether the short-sellers really played such a big role in the declines. Many feel that the real problem is the weakness of the financial institutions. The lifting of the ban by itself is unlikely to spark another precipitous plunge in the market; instead it could actually bolster stocks. Investors who wanted to exit short positions in recent weeks, which would have meant purchasing shares, did not do so because they feared they would not be able to borrow the stock again to short it later on.

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