Evolution of Short Selling Regulations and Trading Practices

Abstract

The role of short sellers in stock trading and efficient pricing is a hotly debated topic. This chapter presented a historical background on the evolution of short selling regulations and the specific rules in effect at the time of major financial crises in the United States. Most restrictions on short selling are triggered by a sharp decline in the stock market. And as short selling is considered an essential tool of efficient markets, therefore the restrictions are usually lifted after market recovery. Short selling restrictions have several formats and can affect the trading process in general, a set of stocks, or a set of market participants. The tick restrictions implemented in the 1930s and short selling restrictions on mutual funds implemented in 1940 both hamper price discovery. In contrast, the Regulation SHO's curb on naked short selling implemented in 2005 and the Securities and Exchange Commission's (SEC) temporary short selling ban on financial stocks in 2008 did not hamper the overall price discovery in stock markets. On February 24, 2010, the SEC approved a variation of the "uptick rule" to place curbs on short sales which applies to stocks that decline atleast 10% in a single day. For such stocks, short selling is allowed only if the price of the sale is above the highest bid price nationally. The nature of this rule makes it similar to the trading halts commonly adopted by exchanges around the world. This rule is expected to prevent abuse of short selling, but not at the cost of severe deterioration in the price discovery process. © 2012 Elsevier Inc. All rights reserved.

Publication Title

Handbook of Short Selling

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