What Kinds of Restrictions Does the SEC Put on Short Selling?

Since the stock market crash in 1929 and the ensuing Great Depression, short selling has been the scapegoat in many market downturns. In a short sale, an investor sells shares in the market, which are borrowed and delivered at settlement.

The intent is to make a profit by buying shares to repay the loaned ones at a lower price. After the Great Depression, the U.S. Securities and Exchange Commission, or SEC, placed limitations on short-sale transactions to limit excessive downside pressure.

While short-selling has been blamed for market crashes and labeled as unethical by some as it is a bet against positive growth, many economists and financial practitioners now recognize short selling as a key component of a well-functioning and efficient market, providing liquidity to buyers and promoting a greater degree of price discovery.

Still, exchanges and regulators have put certain restrictions in the place to limit or ban short selling from time to time. Here, we take a look at some of these measures.

A Brief History of Banning Shorts

Throughout history, regulators and legislators have banned short selling, either temporarily or more permanently, in order to restore investor confidence or to stabilize falling markets under the belief that selling short either triggered or made worse the crisis.

For instance, in the early 1600s, the newly created Amsterdam stock exchange temporarily banned short selling after a prominent short-seller was accused of manipulating prices in the stock of the Dutch East India Company. Likewise, the British government banned shorts following the fallout from the South Sea bubble of 1720.

More recently, at the height of the 2008 financial crisis, temporary short-selling bans and restrictions were seen in the U.S., Britain, France, Germany, Switzerland, Ireland, Canada, and others.

Many governments over the years have taken actions to limit or regulate short selling, due to its connection with a number of stock market selloffs and other financial crises. However, outright bans have usually been repealed, as short selling is a significant part of daily market trading.

The Uptick Rule

For many years after its enactment in 1938, the uptick rule prevailed. This rule was put in place following the Great Depression, and allowed short selling to only take place on an uptick from the stock's most recent previous sale. For example, if the last trade was at $17.86, a short sale could be executed if the next bid price was at least $17.87. Essentially, this rule does not allow for excessive sales pressure from short-sellers and helps keep the market in balance, at least in theory.

Several studies have been performed over the years, revealing no additional relief comes from the uptick rule in a bear market. In 2007, the SEC repealed the uptick rule, giving free rein to short-sellers who soon took advantage in the next stock market crash in 2008. The SEC has since revised the rule again, imposing the uptick rule on certain stocks when the price drops more than 10% from the previous day's close.

The 2010 alternative uptick rule (known as Rule 201) allows investors to exit long positions before short selling occurs. The rule is triggered when a stock price falls at least 10% in one day. At that point, short selling is permitted if the price is above the current best bid. This aims to preserve investor confidence and promote market stability during periods of extreme stress and volatility.

Regulation SHO and Naked Shorts

An essential rule for short selling involves the availability of the stock to be sold. It must be readily accessible by the broker-dealer for delivery at settlement; otherwise, it is a failed delivery or naked short sale. Though in a stock trade this is deemed a renege, there are ways to accomplish the same position through the sale of options contracts or futures.

Regulation SHO is a piece of Securities and Exchange Commission (SEC) legislation, implemented in 2005 to update rules concerning short sale practices. Regulation SHO established "locate" and "close-out" standards that are primarily aimed at preventing the opportunity for traders to engage in naked short selling and other unethical practices.

The "locate" standard requires that a broker has a reasonable belief that the equity to be short sold can be borrowed and delivered to a short-seller on a specific date before short selling can occur. The "close-out" standard represents the increased amount of delivery requirements imposed upon securities that have many extended delivery failures at a clearing agency.

The Bottom Line

Short selling has been found to actually increase market efficiency by providing liquidity and information necessary for price discovery. Research has confirmed this theory by showing that bans or regulations like the uptick rule did not promote stability.

Indeed, short selling remains legal around much of the world today, and temporary bans or restrictions on shorting due to market turmoil have been rescinded once those crises have abated.