Short selling is legal because investors and regulators say it plays an important role in market efficiency and liquidity. By permitting short selling, a strategy that speculates that a security will go down in price, regulators are, in effect, allowing investors to bet against what they see as overvalued stocks. This should help protect the market against speculative bubbles, correct market mispricing, and contribute to more accurate stock valuations. Short selling has experienced temporary bans and strict regulations as each country regulates the ability to short sell within its markets.
The public and its representatives frequently voice disdain for the practice: it seems to profit off the misfortune of others. Besides the movie “The Big Short” (2015), it’s hard to find popular depictions that take the practice as anything but predatory. In addition, when there’s a downturn in the market, those watching their company’s stock go down find it easier to blame the trend on short sellers, not mistakes by company management or wider trends.
Key Takeaways
- Short selling is an investment strategy that speculates on the decline in the price of a stock or other security.
- The Securities and Exchange Commission (SEC) adopted Rule 10a-1 in 1938 so that market participants could legally sell short shares of stock only if they occurred on a price uptick from the previous sale.
- The uptick rule was eliminated in 2007, following a yearslong study by the SEC that concluded that the regulation did little to curb abusive behavior and could limit market liquidity.
- In 2010, the SEC adopted the alternative uptick rule (Rule 201).
- During times of market crisis, when stock prices are falling rapidly, regulators have stepped in either to limit or prohibit the use of short selling temporarily until order is restored.
Despite these perceptions, short selling remains a legal and regulated part of the financial markets, recognized for its role in balancing the hype typical of those pushing a security's price up and as providing a means for risk management and hedging. Nevertheless, the practice of short selling was one of the central issues studied by Congress before enacting the Securities Exchange Actin 1934 and is thus part of the rationale for the regulatory regime for U.S. securities. The act gave the Securities and Exchange Commission (SEC)broad authority to regulate short sales to prevent abusive practices.
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Understanding Why Short Selling Is Legal
Short selling is legal because U.S. regulators say it's part of the market's overall process of price discovery and market efficiency. By allowing investors to sell stocks they've borrowed since they think they're overpriced, short selling should help correct inaccurate prices in the market, hopefully bringing them more in line with their fundamental value. Especially during speculative bubbles, those shorting a security can uncover how there's too much optimism in a company's valuation, acting as a counterbalance in the market. Also, by borrowing and then selling securities, short sellers help provide liquidity while managing risk and hedging against volatility.
Regulatory bodies like the SEC oversee short selling to minimize abuses and ensure it contributes these positive functions to the market. When there's a crisis and stock prices are falling rapidly, regulators frequently step in either to limit or prohibit altogether short sales until it passes.
Regulators might also temporarily restrict certain securities from short selling when there's turmoil in the market. This happens when they think that certain stocks are at risk of excessive downward price pressure and may be prone to modern-day bear raids. These have happened historically when traders colluded to drive a stock price down by heavy short selling or spreading negative rumors about a stock with the aim of profiting from the subsequent decline. There remains controversy about whether such bans are effective.
Short Selling Becomes Legitimate
The SEC adopted the so-called “uptick rule,” Rule 10a-1, in 1938, which says that market participants can sell short shares of stock only when the price is an uptick from the previous sale. Short sales on downticks were forbidden, though there were some narrow exceptions. This rule prevented short selling at successively lower prices, a strategy intended to drive a stock price down artificially.
The uptick rule thus allowed unrestricted short selling when the market was moving up, increasing liquidity and acting as a check on upward price swings. Despite being legal and its apparent benefits, many policymakers and the public remained suspicious of the practice. Profiting from the losses of others in a bear market just seemed unfair.
As a result, in 1963,Congress directed the SEC to examine the effect of short selling on price trends. The study showed that the ratio of short sales to total stock market volume increased in a declining market. In 1976, a public investigation into short selling tested what would happen if rule 10a-1 was revised or eliminated. Stock exchanges and market advocates objected to these proposed changes, and the SEC withdrew its proposals in 1980, leaving the uptick rule in place.
The SEC eventually eliminated the uptick rule in 2007, following a yearslong study concluding that the regulation wasn't helping to stop abuses and could limit market liquidity.
Academic studies of the effectiveness of short-selling bans also questioned the efficacy of the uptick rule and similar restrictions. Following the stock market 2007-8 financial crisis, which brought renewed attention to short sellers, many called for greater restrictions on the practice, including reinstating the uptick rule.
The Alternative Uptick Rule
In 2010, the SEC adopted Rule 201, called the alternative uptick rule. Unlike its predecessor, Rule 201 restricts prices at which securities are sold short only if there has been a price decline of at least 10% in one day compared with the previous day's closing price. Once triggered, the rule restricts short selling at a price below the national best bid for the rest of the day and the following day, unless the price comes back within the 10 % threshold.
The adoption of Rule 201 represented a more modern, data-driven approach to regulating short selling, attempting to mitigate the potential downward price spirals associated with short selling, particularly in a distressed market, while still allowing short sales at or above the national best bid. In this way, the SEC can guard the integrity of market prices but not stifle the contribution of shorting to liquidity.
The "Naked" Short Sale
Though short selling has been legal for the past century, some short-selling practices have remained legally questionable. For example, in anaked short sale,the seller doesn't first track down the shares that are then borrowed and sold. Executing a naked short runs the risk that the seller won't, in the end, be able to purchase and deliver the shares promised. It also more easily sparks steep declines in a stock price since sellers can more quickly execute shorts in a volatile environment.
Here are key aspects of naked short sales:
- Lack of borrowing: Unlike traditional short selling, sellers have not borrowed or ensured they can borrow the shares before selling them.
- Settlement risk: Since naked short sellers don't have the shares or locked down that they can be borrowed, there's a risk they won't acquire the shares in time for settlement, leading to a failure to deliver.
- Regulatory perspective: Naked short selling is generally seen as potentially leading to market manipulation and unfair trades. The SEC has picked up efforts meant to further prevent the practice.
- Influence on the market: The practice can distort the market's supply-demand balance and can be used to manipulate stock prices. The sales can artificially increase the supposed supply of a company's stock, potentially driving down its price, though no stock has really changed hands.
Because of these risks and the potential for abuse, naked short selling is heavily regulated and, in many cases, illegal in financial markets worldwide. In the U.S., the SEC requires broker-dealers to have reasonable grounds to think that shares can be borrowed before enabling any short sale. Also prohibited is selling short and then failing to deliver the required shares at the time of settlement, all to drive down an asset's price.
Short Sale Transparency
In a bid it said was to enhance transparency and oversight in the financial markets, the SEC unveiled rules governing short selling in October 2023. The rules require institutional investors to report their gross short positions to the SEC each month, helping to shed light on a practice ordinarily shrouded in mystery and controversy.
The rules came on the heels of the “meme stock” saga” of the early 2020s, when retail investors drove up the price of certain stocks, including those for the video game company Game Stop, causing substantial losses for hedge funds that had shorted them. The incidents reignited debate around short selling and prompted new regulatory scrutiny.
Before the 2023 rules, reporting requirements for short sales were less comprehensive. The Financial Industry Regulatory Authority (FINRA) did publish short interest reports collected from broker-dealers, but the new rules extended reporting obligations to institutional investment managers to provide a more complete view of marketwide short bets. Investors must also report their total short positions to the SEC every month, as well as certain “net” short activities for specific dates. The moves were meant to give regulators and the public more data to pre-empt or respond to market events.
Critics argue that the regulations could expose investor strategies, posing risks to market participants and possibly affecting market efficiency negatively. Nonetheless, supporters believe the rules were a step toward a more transparent and stable financial market landscape.
When Was the First Short Recorded?
The first documented short sale occurred in the early 17th century when there was precisely one stock to short, namely shares in the Dutch East India Company. Dutch trader Isaac Le Maire was a significant shareholder in the company, and he short sold the company's shares in 1609 to drive the price down as part of a revenge plot after he was banned from the company and the lucrative spice trade. Soon enough, the Dutch government passed legislation to ban the practice.
What Led to the Removal of the Uptick Rule in 2007?
The SEC eliminated the uptick rule in 2007 following a study that spanned several years. The study concluded that the uptick rule did little to prevent abusive behavior and had the potential to limit market liquidity. Additionally, many academic studies corroborated the notion that short-selling bans, like the uptick rule, did not significantly moderate market dynamics, leading to its elimination.
How Did the 2008 Financial Crisis Affect Short Sale Regulations?
The financial crisis of 2007-8 reignited debates on short selling regulations because of the perceived role of short selling in market declines. Post-crisis, there were calls for greater restrictions on short selling, including reinstating the uptick rule. This led to the introduction of Rule 201, called the alternative uptick rule in 2010, which aimed to restrict short selling in a security that has had a significant price decrease. The measure was meant to prevent potential abusive short selling and downward price spirals.
The Bottom Line
The trajectory of short selling regulation in the U.S. shows a decades-long back and forth between allowance of the practice and attempts to curtail the worst forms of it. From the uptick rule in 1938, aimed at curbing abusive short selling during market downtrends, to its elimination in 2007 and eventual replacement with Rule 201 in 2010 to mitigate potential market abuses during financial distress, regulations on the matter continue to evolve. The rules the SEC adopted in 2023 err on the side of greater transparency for these types of trades, despite criticisms that the rule could unwittingly publicize a short selling strategy taking place over time. Through these regulatory shifts, the SEC is aiming to foster a market that's more fair and efficient, even as debates around short selling's ethical and economic implications continue to engage policymakers, regulators, and the public.
