Short Selling: A Brief Overview and Regulatory Update

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  • Executive Summary


    Short Selling


    Executive Summary

    What is Short Selling?

    How Does Short Selling Work?

    The Benefits of Short Selling

    How is Short Selling Regulated

    in the US?

    SEC Regulation SHO

    European Short Selling


    Short Selling Regulation in the


    Effects of Short Selling Bans

    MFA Advocacy













    Short selling is a strategy used by investors to balance

    portfolio allocations and manage risk. It also performs

    a number of important roles in the marketplace aiding with price discovery and providing much-needed


    This presentation offers a brief overview of short

    selling, the benefits it provides for investors and the

    marketplace and how it is regulated in the United

    States and European Union.

  • What is Short Selling?


    What is Short Selling?

    Short selling is a trading strategy fund managers employ when they believe that shares

    of a particular stock are overpriced.

    It generally means borrowing a security (or commodity futures contract) from a broker

    and selling it, with the understanding that it must later be bought back (hopefully at a

    lower price) and returned to the broker.

    The short seller closes out the short position by purchasing equivalent securities on the

    open market, or by using an equivalent security it already owned, and returning the

    borrowed security to the lender.

    Short selling can be used to profit from an expected downward price movement, to

    provide liquidity, or to hedge the risk of a long position in the same security or in a related



  • Types of Short Selling


    What is Short Selling?

    In covered short selling, the investor has made arrangements to either borrow the

    securities or to ensure that they can be borrowed to perform the transaction.

    A naked short sale is one in which the investor does not own the securities at the time

    of the sale and has not made arrangements to borrow them in time to make delivery to

    the buyer within the standard three-day settlement period.

  • 5

    How Does Short Selling Work?

    John Doe holds 100 shares of XYZ Co. - valued

    at $25 per share as a long investment position.

    Mr. Doe is worried about XYZ Cos upcoming earnings report, however, and decides to offset this long position by

    selling short ABC Inc. stock - which is in the same market

    sector as XYZ Co. and would likely also lose value should

    XYZ report poor earnings.

    Mr. Doe makes arrangements to borrow 100 shares of

    ABC Inc. stock at $25 per share and immediately sells it in

    the marketplace netting $2,500. Mr. Doe must return the

    borrowed shares at a specified date.

    As anticipated, the earnings report is negative and XYZ Co. and ABC Inc. stocks both decrease in value to $20 per share.

    Mr. Doe buys back the quantity of ABC Inc. stock needed to cover his short position (100 shares at $20 per share for a

    total cost of $2,000).

    Mr. Doe has earned a profit of $500 on the short sale and offset the decrease in value of the long position held in XYZ Co.

    BORROW 100 shares ABC @$25/share

    SELL 100 borrowed shares ABC @$25

    PROFIT FROM SALE of ABC shares = $2500

    BUY 100 shares ABC@$20

    RETURN 100 shares ABC to lender

    COST TO PURCHASE 100 shares ABC @$20

    = $2000

    LOSS on100 shares XYZ =


    PROFIT from short sale of ABC shares =


    100 SHARES XYZ = $2500 VALUE

  • Why do Investors Engage in Short Selling?

    6 * SEC Securities Lending and Short-Selling Roundtable : 9/29/09-9/30/09

    The Benefits of Short Selling

    The ability to quickly blend positive and negative information into share prices is essential

    for markets to work efficiently.

    Short selling provides the following benefits in the marketplace:*

    Increased liquidity Increased capital formation Improved price discovery, which bolsters investor confidence Decreased transaction costs (e.g. smaller bid-ask spreads) Decreased occurrences of price bubbles and / or crashes Efficient risk allocation Hedging against long term investment positions

  • 7

    How is Short Selling Regulated in

    the US?

    The SEC is the government agency tasked with regulating securities markets in the U.S.

    Throughout the years, they have developed and implemented various regulations related to short selling,

    including Regulation SHO, which was finalized on August 6, 2004 and has been supplemented in recent


    Regulation SHO was adopted under the Securities Exchange Act of 1934 to meet the following goals,

    according to the SEC:

    Short Selling Regulations in the U.S.:


    Establishing uniform locate and close-out requirements to address problems associated with failures to deliver, including potentially abusive naked short selling.

    Creating uniform order marking requirements for all equity securities sales, requiring participants to label orders placed with broker-dealers

    as long, short, or short exempt.


    Regulation SHO requires a broker-dealer to have reasonable grounds to believe the specified security can be borrowed so that it can be delivered on

    the due date before executing a short sale. Broker-dealers are required to

    document the location before making the transaction.

    Broker-dealers must close-out any outstanding failure-to-deliver positions

    (open-fails) by the settlement day, following the settlement date.



    Close-out Requirement


    Regulation SHO applies to short sales of equity securities and includes the

    following key components:



    Regulation SHO has been amended since implementation in 2005 to include new rules governing

    short selling:

    Rule 201

    Known as the alternative uptick rule, Rule 201 was approved in February 2010 as an amendment to Regulation SHO. The rule includes a short sale-related circuit breaker, which is triggered when a securitys price declines by 10 percent or more in a day. Once triggered, short selling of that security is only permitted if

    the price is above the current national best bid.

    Rule 201 applies to all equity securities listed on a national securities exchange,

    regardless of whether they are traded in an exchange or over-the-counter markets.

    Rule 204

    In July 2009, The SEC amended Regulation SHO to include Rule 204 to reduce

    fails-to-deliver and curb abusive naked short selling. The SEC developed this rule in response to persistent fails to deliver in the marketplace, penalizing firms if they do not close out fails in a timely fashion.

    Short Sale Data Several self-regulatory organizations (SROs) provide daily aggregate short selling

    volume in formation on their websites and on a one-month delayed basis including information on individual short sale transactions.

  • 10

    European Short Selling Regulations

    European nations traditionally regulated short selling individually, rather than collectively through

    the European Union (EU). For example, during the financial crisis in 2008, several EU member

    states implemented independent emergency measures restricting or banning short selling.

    As a result, the European Commission released a proposed regulation in September 2010 related

    to short selling and certain aspects of credit default swaps (CDS). The proposal introduced

    common requirements and powers to harmonize regulation across EU member states.

    After months of negotiations in the European Parliament, the Council of the European Union and

    European Commission agreed to a final text in October 2011. It was signed on Wednesday, March

    14, 2012.

    European Union and Member State Regulations:

  • 11

    European Short Selling Regulations

    Short selling regulation was signed on Wednesday, March 14, 2012.

    The European Securities and Markets Authority (ESMA) developed is draft advice, and presented it to the European Commission on April 20, 2012.

    The European Commission adopted its final delegated acts and regulatory technical standards on July 5, 2012.

    The Regulation took effect on November 1, 2012.

    European Union and Member State Regulations:


    The regulation requires reporting of net short positions to regulators over a

    certain threshold, and public disclosure of net short positions over a higher


    The regulation further requires parties entering into a short sale to have

    borrowed the instruments, entered into an agreement to borrow them or

    made arrangements with a third party under which that third party has

    confirmed that the share has been located.

    Reporting &




    The new regulation covers a number of items1, including:

    Transparency &


    The regulation also pr