SEC's New Rule for Short Selling Is a Non-Rule

The U.S. Securities and Exchange Commission (SEC) chairman Mary Shapiro announced a new rule to "restrict" short selling today, and it has been approved by 3-2 vote.

According to the announcement, this new rule will do the following:

"... a circuit breaker would be triggered any time a stock has dropped 10 percent in one day. At that point, short selling would only be permitted in a security if the price is above the current national best bid."

The circuit breaker, therefore, won't stop short selling even when the stock has dropped 10 percent. Short sellers will still be able to short as long as the price is above the current national best bid (sort of uptick rule, and SEC actually calls it "alternative uptick rule").

Creating the national best bid should be very easy for the outfits that can do "flash-trading" and "high-frequency trading", both of which SEC is supposed to have been investigating oh for such a long time. Instead, the agency is busy harassing Toyota.

With flash-trading and HF trading, it should be very, very easy to keep the drop within the 10% threshold while these quant traders short away the stock.

And this non-rule will be effective for the day the stock plunges 10 percent, and the day after.

Why does SEC even bother? Is it just to show that they are doing "something" to justify their salaries and benefits?

I have a feeling that this will join the list of "unintended consequence" very shortly. What unintended consequence I haven't yet figured out. One possibility is a no-bid market. Who wants to invest and trade in a market which is openly manipulated by meaningless regulations and by the likes of Goldman Sachs?

Another possibility is that investors/traders who are long the security may get trapped, unable to unload their shares. I am sure the brokerages and banks will have mechanisms to distinguish long sellers from short sellers, but somehow I can't seem to trust such mechanisms.

In a crash like we had in September-October 2008, you may want to dump your holdings as fast as you can, whatever the price, even if you may get a sizeable haircut. It was better to lose 10% by selling out than to lose 50, 60, even 70% several days, weeks, months later. Some stocks lost more than 90% before the market bottomed in March 2009.

This potential entrapment of long sellers is perfectly in line with another recent SEC ruling that will allow money market funds to refuse redemption in a crisis.

Capital and information want to flow in and out freely. Any effort to stop the free flow will eventually backfire.

After the damage is done, the government will say "Who could have known? But we meant well..." A lot of people (other than people with their heads in the sand, including government bureaucrats) will have known. Intention will be irrelevant.

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