What is Short Exempt?

Short exempt refers to a short sale order exempted from the uptick rule regulation, as governed by the Securities and Exchange Commission’s (SEC) Regulation SHO. The current implementation of this regulation contains a modified version of what was known as the uptick rule. The current regulation allows for a comparatively small number of restrictions, and within those restrictions are an even smaller fraction of exceptions to that rule. These exceptions are intended to allow brokers to best serve their customers in panicked markets.

Key Takeaways

  • Short selling, profiting from falling prices, can't be done in a predatory way during panicked markets.
  • The SEC regulation that inhibits these practices is regulation SHO, and its provisions are more colloquially referred to as the uptick rule.
  • The few exemptions to this rule occur during times of fast-moving markets which make for scrambled quotes and trades that may fall outside of the normal bid and ask prices.

Understanding Short Exempt

Short exempt orders are allowed to initiate short selling of securities even during times that may be otherwise restricted. These are statistically very rare and most retail traders would not experience the effects of these restrictions or their exemptions because the modified uptick rule only kicks in under extreme circumstances, and the exemption to this rule occurs in only vary rare cases within those extreme circumstances.

Short Selling

Short selling typically refers to an exchange of securities through a broker on margin. Broker-dealers loan securities to clients for the purpose of short selling. Broker-dealer short selling will have various stipulations that must be followed and can be complex for an investor. Generally, the broker-dealer will transact these securities for the client for the purpose of short selling which requires the transaction to include short or short exempt markings.

Short selling in securities is intended to help participants profit during falling markets, and bring more participants into the markets at a time when investors may be retreating. To discourage any amplifying effects in a panicked market, The SEC implemented Regulation SHO in 2005 and modified rules regarding short selling orders in 2010.

Regulation SHO

Regulation SHO is a legislation overseen by the SEC which includes rules for short sell trading strategies. Its primary goal is to help ensure the liquidity of securities involved in a short sell for full execution. These rules come in to play during times when the market may be at risk of losing participants (liquidity) and discourages those who would exploit such a market.

In 2010 the SEC modified Rules 200(g) and 201 of Regulation SHO to loosen the constraints on short selling. The prior rule allowed an investor to only partake in short selling when the underlying security experienced an uptick. But studies showed that this behavior, in normal market operations, did not contribute significantly to panic behavior or rapidly falling prices.

Therefore, the new 2010 rules modified this regulation so that it only stops short selling on a security when its price has decreased by 10% or more from the previous day’s closing price. Once such a condition is triggered, the restriction remains in place from the time of the decrease to the next closing day. This ruling is required to be maintained by all U.S. exchanges.

Standard market procedures require all security trade orders to be marked long, short or short exempt. The short exempt marking was added under the 2010 modifications. Thus, an order to buy is marked long and an order that complies with Regulation SHO is marked short. A short sell order marked as short exempt is an order that is being transacted beyond normal procedures under Regulation SHO.

Rare Exceptions in Panicked Markets

Though the SEC oversees brokers who issue short-sale orders, they do not execute regularly scheduled audits or required regularly filed reports by brokers. Instead, the SEC expects broker-dealers to be self regulating, by maintaining their own records which are subject to audit at any time. With this in mind, broker-dealers are required to document their polices for how they mark orders as exempt, and, if audited, provide evidence that they have followed their documented policies and procedures.

Broker-dealers therefore mark an order short exempt if they believe it qualifies for an exception. The primary exception is the use of non-standard pricing quotes for trade execution. That means that if prices come in outside the National Best Bid or Offer (NBBO), they can initiate a short-sale order that they judge would have qualified as an uptick in more orderly markets. Marking for these orders is signified by SSE. All orders marked SSE will be closely checked by self-regulatory organizations and the SEC for compliance with Regulation SHO exceptions.