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SHO part Two


Like Boo needs any help lately...

In January of this year, the SEC implemented Part One of Regulation SHO. I wrote about the urban legend it caused back in January and warned people to not get too carried away. It turns out that Part One had no discernible impact on the market. It certainly didn't reduce short selling pressure as we have had a string of record-high short interest readings on the major exchanges ever since.

The far more controversial Part Two of Regulation SHO goes into effect next week. This part of the regulation makes it easier to initiate short positions on select stocks during trading hours and all stocks outside of regular and extended trading hours. I suspect the effect of this part of the regulation will not be so transparent. Part Two is described as a year-long test.

Let's get into the details...

Part One

To short a security, someone must first borrow the stock so you can make the sale. In order to make it easy for short sellers, traditional rules allow a market maker or broker to simply create a borrowable share out of thin air under the assumption they will be able to secure a real borrowable share later. In certain heavily shorted stocks, however, the broker or market maker is not able to find a share to borrow in a timely fashion.

Previous SEC rules generally required borrowable shares to be found within 3 days of the short sale. If no shares were to be found, the short sale was required to be unwound. Few bothered to follow the rule, especially for smaller stocks with small floats. In response to complaints from companies, individual investors, and as a result of the SEC's ongoing "research" into the hedge fund industry, the SEC came up with Reg. SHO. Part One of the implementation of Reg. SHO addresses this borrowing issue. It went into effect in January of this year.

Under Part One, if more than 10,000 shares and at least 0.5% of an outstanding short position in a company has not yet been legitimately borrowed and this condition has been in place for five consecutive trading days, the stock goes on a "Threshold List." If a stock is on the Threshold List for thirteen consecutive trading days, then the SEC steps in. The offending market maker who handled the transaction is required to call in the short sale immediately (this creates buying pressure in the stock). In addition, that market maker cannot facilitate a short sale in that security for a period of time unless they first find shares (remember, normal procedure is short first, find shares later). The broker who handled the trade (if any) is subject to the same penalty.

The urban legend is that if a stock appears on the various Threshold Lists, it will rise dramatically because of a "short squeeze." Nope. While Reg. SHO sounds good, this rule is essentially useless for combating short sale abuses. There are enough exceptions to drive a truck through. The primary hole is any "illegal" borrows prior to the time the stock is published on the Threshold List are not affected by the forced call in. Additionally, the 13-day requirement is excessively long. A stock could conceivably be on the list all month except for one day and nothing will be done about it.

One useful side effect of Reg. SHO Part One is the requirement to tag share transactions as short sales. While there is no infrastructure in place to make use of this information, requiring the tag is a necessary first step. Tagging will eventually help curb abuses, assist in corporate governance, and simplify dividend-related income tax calculations - once technology is put into place to make use of the tag.

Part Two

The second part of Reg. SHO kicks off Monday. This is a grand experiment by the SEC to see what happens to the market when traditional anti-manipulation protections are removed.

In order to initiate a short sale on a non-ETF equity, you have to wait for an uptick on the bid. Those people who spend much of their time shorting stocks tell me this is an agonizing process at times as they watch stocks they want to short decline via "natural" selling, all the while losing out on potential profit tick-by-tick.

Part Two of the SHO rule removes the bid uptick rule in three categories of securities.

Category A securities are a subset of the Russell 3000 (the top 3000 publicly traded companies sorted by market cap) chosen by the SEC. You can find the list here. The uptick rule will be suspended on these companies for one year. Short sellers can short without any barrier to initiating their position. Category A stocks are fair game 24 hours.

Category B securities are comprised of Russell 1000 stocks (the top 1000 publicly-traded companies sorted by market cap) not already on the Category A list. A list of these companies may be found here. You can short these companies without an uptick from 4:15pm to 4:00am ET - basically the evening extended hours session up to the morning extended hours session.

Category C securities are all securities not on the Category A or Category B list. You can short these securities without an uptick from 8pm to 4am ET.

The point?

Market participants who rely heavily on short sales complained to the SEC they were put at a disadvantage due to the uptick rule. The SEC responded by determining these actors were trustworthy enough that the uptick rule was not necessary. The biological byproducts hit the fan and this "compromise" was born where the SEC will "study the matter" based on this test.

The idea is the (overburdened) staff of the SEC will be able to collate a year's worth of trading data from among these three categories, compare it to the "passive control" of historical patterns and the "active control" of non-Category securities to detect whether the removal of the uptick rule benefits, harms, or has no effect on the securities market.

Excuse me while I giggle... There, I feel better. Sorry about that.


If you've got the idea I think this is one of the dumbest ideas of all time, you get your brownie points for the day. The SEC has said other controls in place (specifically program-trading circuit breakers) will prevent any outsized problems. They also note they can cancel the experiment at any time.

This presumes they can stay on top and rapidly analyze all the data in real time. If this rule generates adverse market conditions, the move will be so devastatingly swift it will be all over but the bankruptcies from margin calls before the SEC has a chance to get the first syllable of their apology out of their mouths. It is fair to note the SEC is actively encouraging outside firms to provide their own analyses of the impact of this experiment. It's also fair to note the exchanges are providing the data to the SEC on a four-week lag.

I would expect the actors who pushed for this rule would play nice for at least a year in an effort not to look their gift horse in the mouth. In general, a market without these kinds of rules will have swifter downdrafts than people are used to. This will increase volatility primarily through increased velocity to the downside. I'm not an options expert, but I expect option premiums for at least put contracts will rise as put sellers will require more premium for the insurance implicit in a put purchase.

I believe you'll see this most often on earnings misses or other adverse news. Knee-jerk reactions are already severe in many of these situations. With no uptick rule to retard short selling, these stocks are going to see ugly declines very rapidly.

What is interesting about this test is the SEC already has a test operating in real time on the Pink Sheet market. How's that worked? Several lawsuits are pending as companies discover reported short sale levels in excess of the total number of shares issued. Yes, I'm aware of the fact Pink Sheet stocks are special situations where manipulation is made possible by low volume and scanty participation. I just find it interesting the SEC would even attempt duplicating that failed experiment in the broader market.

For more information, the SEC has published a Frequently Asked Questions list. For those stat geeks in the Minyanville audience, published data relating to this grand experiment will be available (on a 4-week lag) via links shown on this page.
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