Here We Go Again?

Regulators move to change short-selling restrictions

SCOTT WARNER, ASSOCIATE DIRECTOR AND PORTFOLIO MANAGER, PAAMCO

Amid widespread panic in equity markets, the Securities and Exchange Commission (SEC)adopted restrictive measures to combat coordinated short selling by speculative pools of capital by instituting an “up-tick” rule. That was in 1938. Fast forward 72 years, and many of the same measures are being applied, modified, and re-applied to today’s equity markets.

On 24th February the SEC adopted an “alternative up-tick” rule which is expected to go into effect later this year. This rule is designed to trigger a circuit breaker if a stock price declines by more than 10% intra-day. After such a trigger, short-sellers would only be able to short additional shares at a price above the current national best bid. Effectively, this ruling will allow investors holding long positions to sell ahead of potential new short-sellers. The primary goal of the SEC’s legislation is to promote market stability during periods of uncertainty, hence the circuit breaker feature of the proposal.

The US is not alone in taking actions to impede short-selling. Similar reform is not only being contemplated but is being actively introduced in Europe. German Finance Minister Wolfgang Schaeuble and Chancellor Angela Merkel have recently laid out plans for a comprehensive regulatory overhaul which includes proposals to eliminate naked short selling and speculative trading of government bonds. While the country’s financial regulator BaFin has already issued some guidance on the proposals, the full scope of the order remains unclear at this early stage.

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Measures are also being considered in Asian markets. In March, the Securities and Futures Commission (SFC), Hong Kong’s financial regulator, also came out with new legislation with regards to short selling. The SFC will seek to require weekly reporting of short positions if certain ownership tests are met. As proposed, this initiative would only apply to roughly 100 Hong Kong listed companies, but the proposal has particularly important ramifications. Martin Wheatley, the chief executive of the SFC, also chairs the taskforce on short-selling at the International Organization of Securities Commissions, which represents more than 100 global regulatory bodies. A very similar initiative was brought to light by the Paris-based Committee of European Securities Regulators (CESR). The CESR has recommended a Pan-European disclosure of short positions in a similar fashion to those in Hong Kong. Clearly, this policy has the potential to act as a global precedent.

Estimated Market Impact
While the goal of the SEC proposal is to provide stability, it comes at a cost. Short-sellers frequently serve as providers of liquidity in equity markets, so restricting their trading could marginally impair equity market liquidity. While evaluating this impact, a recent study calculated that from January 2008 through February 2010, only about 2% of the current S&P 500 constituents would have triggered the circuit-breaker on an average trading day. Furthermore, it is important to note that this average masks significant variability in the data. In recent months, only about 0.2% of the S&P 500 would have triggered the circuit breaker, versus nearly 15% in October 2008. Clearly, under normal market conditions, we would expect minimal market impact.

Another important consideration in assessing the potential market impact is that the rule is not volatility-adjusted for each stock. Simply put, the rule does not differentiate between high and low volatility stocks. As such, we expect that higher volatility stocks such as small caps will be significantly more likely to trigger the circuit breaker than their less volatile brethren.

While the impetus behind the rule lies in limiting predatory shorting, we believe that the largest impact of this rule change, however, will be felt by market makers and broker dealers. In order to maintain compliance with the SEC’s new mandate, these market participants will be required to make significant investments in additional infrastructure to ensure compliance with the new regulations.

What impact on hedge fund strategies?
As a group, hedge funds account for the vast majority of short-selling in the marketplace. But that’s where the similarity ends. Depending on a manager’s particular strategy, the impact of these rule changes varies significantly.

For fundamentally focused long/short equity managers, we expect the rule changes here in the US to have a negligible impact. In speaking with several managers on the issue, we found that the general perception is that these restrictions come as welcome relief versus some of the other potential outcomes that had been contemplated. Anecdotally, one portfolio manager analysed every short sale in his portfolio for the last three years, and found that the circuit breaker would have applied to less than 1% of the total number of short trades during that time. One of the biggest reasons for the limited impact on this strategy lies in the fact that fundamentally focused managers are less likely to short a stock after its already fallen more than 10% in a day.

Managers in the equity market neutral strategy will likely be slightly more impacted given their tendency to trade a larger number of positions and have higher turnover than more fundamentally focused managers. Had the rule change been to simply reinstate the up-tick rule, the impact could have been significantly larger, particularly in the high-frequency space. As it stands, given the limited scope of the restrictions, it should not have a material impact for most managers.

While we expect long/short equity and equity market neutral to be the strategies most directly impacted by the regulation changes, other hedge fund strategies such as convertible bond hedging and event driven equity may also be moderately impacted. Clearly, any strategy reliant on shorting equity positions to hedge risks or generate returns could be impacted, at least marginally.

Conclusion
In 2007, the SEC eliminated the up-tick rule that had been in place since 1938. Following a three year investigation into the effectiveness of the original rule, the commission voted to repeal the regulation. At the time, they concluded that the up-tick rule “modestly reduces liquidity and does not appear necessary to prevent manipulation.” The reinstatement of a modified version of the rule certainly is highly contradictory to the findings of the committee just three years ago.

Our view is that this ruling is likely to be largely a non-event. Under substantial political pressure, the SEC has chosen to adopt the least activist measure at their disposal. Many members in congress have called for a full reinstatement of the up-tick rule, which would have much broader implications than the modified proposal that the SEC has presented. By adopting this moderate stance, the SEC is attempting to strike a compromise, and like most compromises, neither party can claim victory.

The measures being implemented in Germany merit closer monitoring as they are substantial and far-reaching. Given the backdrop of a tense situation in Greece and across the Eurozone, political pressure is on legislators to take action. While we are still in the early stages and do not yet have clarity on how this will play out, it is likely to have more of an impact on markets than the changes in the US.

Scott Warner, MBA, CFA, FRM is an Associate Director and Portfolio Manager at Pacific Alternative Asset Management Company. PAAMCO runs moderate volatility hedge fund of funds portfolios and had assets under management of $9.8 billion at 31st March 2010.