In markets like these, it is only reasonable to expect investors to try to profit from a drop in share values. And one of the most popular ways of doing so is through short selling. Short selling occurs when an investor borrows a stock and sells it immediately in hopes of buying it back at a lower price before returning it to its owner. The investor pockets the difference. (Be sure to read our Short Selling Tutorial for a more in depth look at this concept.)

SEC Admits Short Selling Ban Was a Flop
Unfortunately for traders who like this game, the practice of short selling has become the subject of increased regulatory attention. And in a recent instance, it was banned outright. In September 2008, the SEC slapped a temporary ban on shorting the shares of a number of hard pressed financials like Morgan Stanley (NYSE:MS) and Citigroup (NYSE:C) that had seen their share prices pummeled by repeated bear raids.

The ban was lifted a few weeks later in what essentially amounted to a financial standing eight count.

However, it now appears that the referee has had some regrets about making the call. SEC Chairman Christopher Cox admitted in a recent Reuters interview that the costs of the decision outweighed the benefits. The move apparently led to a material reduction in market liquidity and generally failed to halt the market slide.

More Regulatory Tinkering in the Works
The government is considering taking another stab at the short selling issue. A bill proposing to reinstate the "uptick rule" was presented to U.S. Congress recently.

The rule, which originally was implemented during the stock market crash of 1929, allows the short sale of stocks only in instances where the last trade was executed at a price higher than the previous trade, or on an "uptick". The uptick rule was repealed by the SEC in 2007.

Proposed Bill Gets Mixed Reviews on Wall Street
Rather than eliciting universal condemnation, the bill has received a mixed reception on Wall Street thus far. The chairman of U.S. discount brokerage giant Charles Schwab (Nasdaq:SCHW) has come out strongly in favor of the move, arguing that reimplementation of the uptick rule is a necessary step toward reducing market volatility and restoring investor confidence. Not surprisingly, another firm that would stand to benefit from restoration of confidence amongst small investors, T. Rowe Price (Nasdaq:TROW), has come out in favor of the legislation, too.

Facilitators of institutional trading, like UBS (NYSE:UBS), Deutsche Bank (NYSE:DB) and Knight Capital (Nasdaq:NITE), argue that the rule is obsolete in a world where computers can trade millions of shares in a matter of seconds. Moreover, if the rule were applied only to the New York Stock Exchange, it would likely lose market share to other global exchanges not subject to the rule.

Hedge Funds Could Take a Hit
One group of major losers would be the short-biased hedge funds that had a stellar 2008. Compared with a 38% loss for the S&P 500, these bearish funds had an average gain of 34% last year. While there is no way of discerning how much of these returns can be attributed to the alleged manipulative short selling practices, the reinstatement of the uptick rule would erase any bias. Specifically, the operational challenge of complying with the rule on every short sale would likely crimp returns for hedge funds.

The Bottom Line
Given the prevailing interventionist mood on Capitol Hill, the bill should pass easily. However, small investors should not buy into the notion that this measure will have a definitive positive impact on market volatility. Only a significant improvement in economic fundamentals can accomplish that.

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