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SEC Bans Short Selling on Financials

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What does it mean for you?

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It's official. Bears, forever unwelcome, have now been formally outlawed. Last night the Securities and Exchange Commission moved to formally ban short selling on 799 financial stocks effective immediately. The ban will run to Oct. 2, but may be extended, the SEC said, though no longer than 30 days.

See the list of companies affected here.

Minyanville's Why Wall Street Will Never Be the SameThe SEC said the move was needed "to protect the integrity and quality of the securities market and strengthen investor confidence." SEC Chairman Christopher Cox, in a statement, said "The commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets."

The U.K.'s Financial Services Authority announced a similar ban midday Thursday, spurring a rally in U.S. markets. The move was a clear telegraph to financial markets here that the U.S. markets here would be next.

The question, what does this mean for our markets?

The initial answer can be seen in the S&P futures, as we write up 65 points, 5.4%. But what next?

First, what is short selling?

Short sellers borrow shares of stock and sell them in the market, hoping to buy them back at a later date at a lower price. The SEC, and firms such as Morgan Stanley (MS), JP Morgan (JPM) and Goldman Sachs (GS), among others, have been concerned with the practice of naked short selling. A naked short sell is an abuse of rules (rarely enforced) that prohibit traders from selling a stock without first physically locating and borrowing the stock and never intending to deliver it to the buyer at a later date.

Most people think of short sellers as bearish hedge fund operators holed up in dank offices betting against the fate of a hapless corporation somewhere. But the reality is that the majority of short selling in markets is executed as some type of hedging transaction. For example, a firm that specializes in, or makes markets in, options, may sell shares of stock short to remain "delta neutral." In English, this means the options trader is not exposed to the stock's price movement.

Why would someone do this? The biggest reason is liquidity. The first casualty of the short selling ban will be liquidity.

The second casualty will be the synthetic demand that short sellers represent. Every share sold short must eventually be bought back at a later date. This layer of demand serves the critical purpose of softening declines. It is, at its very core, what makes a market a market; buyer and seller meeting to transact differing opinions about what constitutes value.

With short sellers absent, shares will initially rise. But once demand is satisfied, there will be no softening any declines. This could potentially create a vacuum below market prices and exacerbate a decline.

Surely the SEC knows this, so why are they doing it? The gambit by the SEC is two-fold. First, they hope to extend the ability of financial firms to survive this crisis by removing the pressure short sellers may cause to share prices. Second, they understand that the Treasury Department and the Federal Reserve most likely have a series of follow-on maneuvers planned that they hope will address the fundamental issues driving the debt crisis, which is the quality of the balance sheets of many banks and financial institutions.

The important thing to keep in mind is this is not a solution to the crisis, but a gambit. The risks are two-sided. It may succeed, but at a severe cost to the American taxpayer and to capital markets as we know them. If it fails... well, the consequences of that are rooted in the very origins of these policies: the Great Depression.

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No positions in stocks mentioned.

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