What Is Regulation SHO?
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.
- Regulation SHO is a SEC rule that governs short sell trading strategies.
- Aiming to prevent unethical practices, Regulation SHO applies standards to the behavior and practices of both brokers and traders/investors.
- In 2010, Regulation SHO was amended via changes to its Rule 201. Rule 201 stops short selling on a security when its price has decreased by 10% or more during the trading day, mandating that new bids be above the current price.
Understanding Regulation SHO
When it was implemented on January 3, 2005, Regulation SHO represented the first time that rules regarding short sales had been updated since 1938. Short selling typically refers to an exchange of securities through a broker on margin, which basically involves borrowing. Broker-dealers loan securities to clients for the purpose of short selling.
Regulation SHO's "locate" standard requires that a broker has 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.
Changes to Regulation SHO
Over the years, Regulation SHO has experienced amendments. After the initial adoption of the regulation came two exceptions to the close-out requirement: the grandfather provision and the options market maker exception. There were ongoing concerns, though, regarding instances where requirements were not being met for closing out securities that had failed to deliver positions. Those concerns eventually led to the elimination of both exceptions by 2008. the result was he strengthening of the close-out requirements by applying them to failures to deliver as a result of a sales of all equity securities, as well as cutting down the time allowed for failures to deliver to be closed out.
Further changes to Regulation SHO came in 2010. One of the primary issues the SEC had originally sought to address with Regulation SHO was the use of short selling to artificially force down the price of a security. It specifically dealt with this problem via the modification of Rule 201, which limits the price that short sales can be affected during a period of significant downward price pressure on a stock.
Rule 201 is triggered in the midst of a substantial decrease in a stock's price during intraday trading—specifically, when its shares fall at least 10% in one day. It mandates that short-sale orders must include a price above the current bid, a move that prevents sellers from accelerating the downward momentum of a security already in sharp decline.The intent is to prevent short selling that, in particular, is meant to be abusive or manipulative of the securities share price.
As a part of Rule 201, trading centers are required to establish and enforce policies that prevent short sales at what would be deemed impermissible prices after a stock is dealt a 10% decrease in its price within the trading day. This would trigger a “circuit breaker” that would bring price test restrictions into effect on short sales on that day and into the next trading day.
Certain types of short sales can quailfy for an exception to Regulation SHO. These orders are known as short exempt , and are marked by brokers with the initials SSE. The primary exception is the use of non-standard pricing quotes for trade execution.