Threshold Lists Shrink, But Stock Volatility Remains
December 10, 2008
Exchanges’ threshold securities lists have shrunk dramatically since the Securities and Exchange Commission instituted short selling restrictions in September. While the contraction reflects regulatory efforts to reduce failures to deliver securities, it may not be helping to meet the commission’s larger goal.
The New York Stock Exchange’s threshold list, which included about 100 securities in August, fell to single digits by November and as low as three on Dec. 1. Meanwhile, the Nasdaq Stock Market’s threshold stocks--in the 300 range in mid-summer--dropped below 100 by late October and 50 late last month. Under the Regulation SHO short-sale rules that went into effect in 2005, threshold securities occur when delivery failures exceed 0.5 percent of an issue’s total shares outstanding, prompting mandatory close-out provisions on all future fails longer than 13 days. A decrease in threshold stocks means fewer open fails.
The reduction of the threshold lists began in earnest Sept. 17, when the SEC imposed Rule 204T on an emergency basis. That rule, which the SEC is seeking to make permanent, requires short sellers to borrow securities within three days of a transaction or purchase them in the open market by the start of trading on the fourth. Comments on the interim hard-close rule are due by Dec. 16.
Michael Trocchio, senior associate at Bingham McCutchen in Washington, D.C., said that delivery failures stopped almost immediately after the emergency rule. “Clearing firms got very uptight about fails, and so they tightened up their securities lending policies,” he said, noting that the commission also put into effect Rule 10b-21, a naked short-selling antifraud rule. Trocchio, a former SEC staffer who worked on the concept release leading up to Reg SHO, added that the lists continued to dwindle in October as firms worked through their open fails.
Reducing open fails was one of the SEC’s main goals, according to its emergency order: “We intend these enhanced delivery requirements and the antifraud rule to impose powerful disincentives to those who might otherwise exacerbate artificial price movements through naked short selling.”
The restrictions have prompted brokers to pre-borrow stocks or have concrete arrangements in place, increasing borrowing rates and making some hard-to-borrow securities completely unavailable. For market participants that relied on Reg SHO loopholes to maintain open fails, the new rules have been devastating. Dow Jones Newswire reported Dec. 9 that Copper River Management--once a $1 billion fund--is liquidating and returning money to investors. Reportedly, Copper River’s collapse was due in part to its holding sizable short positions when the emergency order became effective. The hard close forced short sellers to “buy in” securities at market prices, often at large premiums, to cover positions.
“The reduction in fails and especially shorter threshold lists indicate the success of the SEC’s program to address naked short selling,” said Peter Allman-Ward, CFO of Los Angeles-based clearing firm Wedbush Morgan. Allman-Ward said he supports tackling “the problem of short abuses by ensuring that settlement occurs properly so that buyers get the stock that they bought from the short sellers.”
The rules greatly reduced naked shorting, agreed Josh Galper, managing principal of New York-based consultancy Finadium. While Galper sees little downside to the restrictions, he noted that they leave room for untoward behavior. The European Union and Australia, he said, have recently mandated that securities be pre-borrowed before shorting, an approach that eliminates open fails altogether. “The difference is that under the hard close there’s still a small window for potential shenanigans,” said Galper. “It’s saying you can do whatever you want--short to your heart’s content--so long as the securities are delivered later.”
