What is the Regulation SHO
Regulation SHO is a regulation implemented on January 3, 2005, that seeks to update legislation concerning short sale practices. Regulation SHO established "locate" and "close-out" standards that are primarily aimed at preventing the opportunity for unethical traders to engage in naked short selling practices.
BREAKING DOWN Regulation SHO
The "locate" requirement 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" requirement represents the increased amount of delivery requirements imposed upon securities that have many extended delivery failures at a clearing agency.
This regulation represents the first time that short sale regulations were updated since 1938.
Rules and Policies Regulation SHO Put into Effect
After the initial adoption of the regulation came two exceptions – the grandfather provision and the options market maker exception – to the close-out requirement. 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.
Changes to the regulation have included the 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 by the SEC included the adoption of Rule 201, which limits the price that short sales can be affected during a period of significant downward price pressure on a stock. The intent of the rule, according to the SEC, is to prevent short selling that, in particular, is meant to be abusive or manipulative of the securities share price.
One of the primary issues the SEC sought to address with the introduction of Regulation SHO was the use of short selling to artificially force down the price of a security. The introduction of Rule 201 was meant to prevent short sales that could amplify the decline of a security that is in the midst of a substantial decrease in price during intraday trading.
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 one 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.