In February 2010, the U.S. Securities and Exchange Commission (SEC) voted 3-2 to adopt Rule 201 (“Alternative Uptick Rule”) restricting short-selling for the remainder of the day and all of the following day once a stock experiences a 10 percent drop in price from the previous day’s close.1 When the restriction applies, short-sellers must submit limit-orders at a price above the national best bid. Trading venues must establish, maintain and enforce written policies and procedures designed to prevent the execution or display of a prohibited short-sale order. Rule 201 does not provide an exemption for market-makers or opening and closing auctions, but certain arbitrage and odd-lot transactions are exempt. The new rule represented a dramatic policy U-turn because the SEC eliminated the decades-old uptick rule in July 2007.
The SEC adopted Rule 201 to help prevent potentially manipulative or abusive short-selling and bear raids, and, thereby, help restore investor confidence. The Rule gives priority to long-sellers ahead of short-sellers. Restrictions on short-sellers may help prevent further decline in a stock’s price, at least in the short run. By placing restrictions on only a few securities, and not a complete ban, the SEC is attempting to preserve the liquidity and price efficiency-related benefits of short-selling under normal market conditions. Short-sellers represent more than 24 percent of share volume for NYSE-listed stocks and 31 percent of share volume for NASDAQ-listed stocks (Diether, Lee, and Werner, 2009) and prevent stocks from becoming overvalued (Asquith, Pathak, and Ritter, 2005). Short-selling also helps complete the financial markets by allowing option market makers to hedge their positions by short-selling in cash markets. (Battalio and Schultz, 2011).The SEC’s action was severely criticized by many, including the two Republican commissioners, who argued that there was no evidence that short-selling had led to the market crash. Following the SEC’s request for comments, several concerns were raised about the potentially harmful effects of Rule 201, such as reduced market volume, poorer liquidity and price efficiency, wider bid-ask spreads, higher intra-day volatility, overpricing of stock, loss of confidence among investors who buy overpriced stocks and subsequently suffer losses, and increased transaction costs as market participants need to incur significant compliance costs estimated to be $2 billion in the first year and $1 billion per year thereafter (Johnson (2010)).
In Jain, Jain and McInish (2011), we rigorously assess the effectiveness of Rule 201 by analyzing short-selling in the pre-approval, post-approval, and implementation periods, as well as the full-compliance period beginning Feb. 28, 2011. First, we show that before the approval of Rule 201, short-selling volume declines in the minutes, hours and the day following a 10 percent decline. Interestingly, short-selling generally declines in periods following negative stock returns and generally increases in periods following positive stock returns. Before the approval of Rule 201, we do not find any evidence of higher short-selling in target stocks, even on extreme down days. We identify the exact time of a 10 percent price decline and perform minute-by-minute calendar time analysis and percent-by-percent return time analysis. Short-selling is inherently lower after a price decline, even before the approval of Rule 201. Thus, by further restricting the naturally declining short volumes after negative stock returns, the Rule may be destroying the beneficial aspects of short-selling without any apparent benefit of reducing price manipulation.
Second, we find that price recovery is better in the absence of Rule 201. Our return analysis uncovers one reason why short-selling does not increase for the target stocks even prior to Rule 201’s approval. A momentum trader who short-sells a stock on the day it declines 10 percent actually incurs a loss, on average, if he covers the position at the day’s close, the next day’s open, or the next day’s close. After Rule 201, the price recovery slows, which can encourage short-sellers instead of discouraging them.
Third, we examine the effectiveness of Rule 201 by analyzing short-selling volume around the flash crash and by simulating short-sale orders during the 2008 crisis. The Rule 201-compliant execution rate of simulated short-sale orders is as high as 83 percent within five minutes of order submission, which indicates that Rule 201 would not have been binding on short-sellers during the crisis period or flash crash, if it had existed at that time. Furthermore, our research shows that Rule 201 restricts short-selling more during normal periods than during crisis periods, which is the opposite of its intention.
Fourth, we analyze the impact of Rule 201 on the liquidity of affected stocks. The change in closing bid-ask spreads and share trading volume on the day following the 10 percent decline is no better after Rule 201’s full-compliance date than before. Finally, using a multivariate regression analysis that controls for several well-known determinants of short-selling, we find that Rule 201 discourages short-selling only slightly more than the negative returns themselves do. However, Rule 201 is not an effective tool for preventing short-selling during a sudden market crash or a prolonged financial crisis.
The results suggest ample scope for improvements in short-selling regulation. A complete overhaul of the trigger conditions, as well as the exact nature of restriction can better achieve the SEC’s goals. Policy alternatives that require less monitoring should also be considered. And whatever happens to the markets, restricting short-sales is not the panacea.
1) U.S. Securities and Exchange Commission, 2010. Amendments to Regulation SHO, Release No. 34-61595, Washington, DC, available at <http://www.sec.gov/rules/final/2010/34-61595.pdf>.
Asquith, P., P. Pathak, and J. R. Ritter, 2005, Short interest, institutional ownership, and stock returns, Journal of Financial Economics 78, 243-276.
Battalio, R. and P. Schultz, 2011, Regulatory uncertainty and market liquidity: The 2008 Short Sale Ban’s Impact on Equity Option Markets, Journal of Finance 66, 2013–2053.
Diether, K. B., K. Lee, and I.M. Werner, 2009, Short-sale strategies and return predictability, Review of Financial Studies 22, 575-607.
Jain, C., P.K. Jain, and T.H. McInish, 2012, Short Selling: The Impact of SEC Rule 201 of 2010, Financial Review 47, 37–64.
Johnson, F., 2010, In 3-2 vote, SEC limits short sales, Wall Street Journal. February 25, 2010, Page B1.