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Selling Market Makers Short


New regulations could cripple liquidity.

Editor's Note: The following is a discussion of short-selling by 2 Minyanville contributors, Professor David and Professor Warner, which originally appeared on the Buzz & Banter. It is reprinted here for the benefit of the Minyanville community.

Professor Adam Warner:

I'm seeing headers on Briefing regarding shorting stock.

But it looks like it's just a reiteration that they'll now really really really enforce the rules they don't seem to actually bother enforcing.

Oh, and the market maker exemption is now toast.

That's just dumb, in my humble opinion - and not just because market making was my past life and I still have friends in the biz.

There are reasons why market makers need things like that rule, as well as a market maker margin that allows them to take much larger positions than their capital would ordinarily allow. They were created to provide liquidity in the options marketplace. If you take steps to make that more difficult to impossible, you'll thin and severely widen markets. Particularly puts as the net effect of making it more difficult to short will immediately translate into disjointed reverse/conversion markets.

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You could make the case that MM's and specialists aren't needed any more, as the few remaining Wall Street firms can take the other side of trades. Call me crazy, but I would think, after the turmoil we've seen, the last thing you want to do is have less transparent markets.

Bottom line is, you're going to cost MM's and specialists some short term P&L hits, since virtually all will have the wrong position on everything (you're almost always long calls and short puts as a floor trader). But in the long run, their business model actually improves with the wider markets and pumped puts.

And that's ultimately a net cost to basically everyone else.

Professor Rod David replies:

I couldn't agree more with Professor Warner's comment regarding new short-sale rules.

Shorting enhances liquidity, which enables price discovery, which attracts capital. The reverse is also true, which this morning's price action seems to prove.

Crude oil shorts were bullied recently. Ironically that rhetoric coincided with louder public cries for increasing supply. Limit shorting, increase supply. Sounds familiar. So, how's that working out for crude's price? Exactly.
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