Short-Selling Ban May Have Loopholes

Regulators are out to get short sellers. But there may be consequences to their moves that are both important and unintended.

The Securities and Exchange Commission, along with the U.K.'s financial regulator, the Financial Services Authority, banned short selling of a large number of financial shares. The SEC's action involves 799 financial companies and is slated to expire Oct. 2, with a possible short-term extension.

Investors have other tools to protect themselves from falling stocks and to wager on the health of companies. These include credit-default swaps, other derivative trades and options, all of which likely will receive more volume.

Short selling of financial shares, or betting that the prices will decline,hasn't soared lately. Short sales of Morgan Stanley rose to 2.9% of the market value of the company Sept. 16, up from 2% at the beginning of September, though it was as high as 7% in July, according to Data Explorers Inc., a research firm. Short sales of Merrill Lynch & Co. rose as high as 3.8% of the broker's market value last week, from under 2% in early September, though it topped 9% in July.

Many hedge funds have been more active in the credit-default-swap market lately, something regulators didn't address. Derivatives such as credit-default swaps aren't traded on public markets and already have raised alarms for their growth and their lack of transparency. If a surge of volume results from the changes, it might bring potential danger to the financial markets, analysts said.

Friday, several options-market makers said they will stop trading options on financial stocks because the rule change made it impossible for them to hedge their positions by selling shares short. Later in the day, the SEC said it might allow derivative-market makers to short stocks. That would allow investors to continue to bet against companies using the derivative markets, though that can be more difficult than shorting a stock.

Investors still have exchange-traded funds enabling them to wager against the financial sector. These ETFs, such as ProShares UltraShort Financials, use derivatives and are popular among both professionals as well as individual investors.

But the rush to these investments could make it harder for investors to protect their portfolios. The ProShares fund, which gives investors a return that is twice the inverse performance of the financial sector, was temporarily suspended Friday. The company said it will no longer issue new shares, potentially making it somewhat more expensive and cumbersome for new investors to buy shares.

An investor eager to buy a large number of shares of a financial company might want to hedge himself by shorting a company in the same industry. As such, he might be less inclined to do any buying. Some raised concerns about whether the regulatory moves might restrict trading in certain smaller financial shares, compounding the illiquidity that has hounded them lately.

Short-sellers also might turn their sights to companies with heavy financial exposure that aren't covered in the SEC's list of stocks, such as American Express Co., Capital One Financial Corp. and other credit-card companies.

Quantitative hedge funds, a group that plays a big part in daily trading, helping the market's liquidity in the process, often buy buckets of stocks while at the same time selling another large group of stocks. Such trading could be impeded if they can't short certain stocks, adding to the market's volatility.

Then there is the impact on markets such as convertible bonds and merger arbitrage, where traders regularly take short positions to protect themselves as they bet on a company, rather than to express a negative view. Investors who buy a convertible bond usually short the same company's stock, as a hedge, while merger investors typically buy a company slated to be acquired while shorting the acquiring company, simply to protect
themselves.

The SEC's changes could make it harder for financial companies to issue convertible bonds, sell rights offerings or engage in merger deals.
Financial companies sold more than $30 billion of convertible bonds in 2008, often when other markets were closed to them. Sen. Charles Schumer (D., N.Y.) has asked the SEC to look at making it acceptable for convertible-bond holders to continue to short financial stocks, a person familiar with the matter said.

Other markets also might be hurt by the changes, investors said.

"The U.S. and U.K. authorities have just made it technically impossible for the equity-index-futures market to function properly," because arbitragers in this market generally short stocks, including financial shares, said Douglas Kass, who runs hedge fund Seabreeze Partners Management Inc.

And even as academic research supports the role of short sellers in the market, to provide trading liquidity and a skeptical eye, some of these specialists might be forced out of business. That would hurt the pension funds and others invested in these funds to protect their downside.