It appears that U.S. political will for financial reform will fall short of requiring that short sellers first pre-borrow the stocks they sell short. Despite our own fears of banning so-called naked short selling, Germany banned the practice in May in some of its financial stocks. Germany is considering whether to extend the ban to all stocks, and other EU exchanges are eyeing similar initiatives.
True to form, many leading U.S. financial publications have railed against this approach to ending naked short-selling abuses, labeling it a "ban" on all short selling. Unfortunately, their efforts and those of Wall Street's lobbyists seem to be succeeding: U.S. politicians and regulators give no sign they are considering these sensible measures being adopted in the European Union. That's regrettable.
To be clear, while a ban on naked short selling is a good idea, a ban on legitimate short selling is not. Legitimate short selling - in which a short seller sells a share he has borrowed or at least located to borrow - is a critical component of efficient price discovery in the stock market. To ban legitimate short selling would be like banning left turns for cars. But naked short selling - in which a short seller sells a share he does not own, has not borrowed or even located to borrow - is something quite different. Because of the nature of the trade-settlement system in the U.S., current rules allow prime brokers and large institutional traders to sell stock short without first borrowing it.
A pre-borrow requirement in the United States would put an end to naked-short-selling abuses in the U.S. as it has in Germany with respect to the covered stocks. Absent a pre-borrow requirement, naked short selling no doubt will continue to plague American markets, as we saw in the dislocations of 2008 and as recently as the one-day minicrash on May 6.
Even with rule changes implemented by the Securities and Exchange Commission (SEC) in the fall of 2008, as recently as April the average net fails-to-deliver per day at the stock clearinghouse were 400 million shares - with a daily worth of $1.5 billion. Many of these fails are the result of naked short sales, and contrary to popular belief, they are not all in penny stocks or foreign stocks. While Russell 3000 stocks are 5 percent of the daily fail volume in the United States, they account for 20 percent of the value of these fails. Similarly, exchange-traded funds, or ETFs, account for roughly 5 percent of the volume of fails, but they are more than 50 percent of the average daily fails value.
Unfortunately, the SEC's 2008 rule changes cannot prevent a resumption of the huge and destructive fail-to-deliver volumes reached in the summer of 2008. On one day in July 2008, fails-to-deliver exceeded 2.2 trillion shares. These problems will persist and compound until naked short selling is eliminated from our markets through a pre-borrow requirement.
That said, if the political will only allows for something less than pre-borrow, then let's at least do something meaningful. One alternative under discussion deserves every consideration regulators and Congress can muster. I refer to the real-time reporting of short and long volume without disclosing the identity of the long or short seller.
Currently, U.S. exchanges report trading activity in real time but do not disclose whether trades are short or long. Real-time disclosure of actual short and long sales would allow investors and analysts to incorporate meaningful data into market- and security-specific analyses. Such disclosure also would add considerable support to the SEC's proposal to have a consolidated audit trail for all trades. Furthermore, public and instantaneous trade transparency would help legitimate short sellers and other Wall Street institutions dispel doubts about short selling. A real-time disclosure proposal also has the general support of many of the exchanges and the Financial Industry Regulatory Authority.
Finally, this real-time disclosure alternative is cheap, easy and efficient. Traders are already required to mark trade tickets short or long, so the technology is in place that would allow trades to be reported as "short," "market maker short," "buy" or "buy-to-cover" in real time through the Consolidated Tape electronic data system. Moreover, this subtle change wouldn't require a new regulatory apparatus. If the SEC (or Congress) amended the Regulation National Market System, this new disclosure rule could be implemented tomorrow.
When regulation fails (or when a lobby is too powerful), sometimes sunshine is the best disinfectant. It's time to open the windows on Wall Street and let in the sunshine.
Jonathan E. Johnson III is the president of Overstock.com.
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