BRIEF HISTORY OF SHORT SELLING
Short selling was once legal, thanks to Rule 10a-1, way before the creation of the Securities and Exchange Commission (SEC). Traders could profit from declining prices by selling a stock they did not own or borrowed. But following the stock market crash and Great Depression of the late 1920s and 1930s, the US government started their investigation on the role of short selling. At that time, many suspected bear raids for being partly responsible for the market’s downfall.
The US Congress studied short selling, among other major issues, before enacting the Securities and Exchange Act but made no judgments on its permissibility. Upon creating the federal agency, they instead authorized SEC to regulate short sales in order to avoid abusive practice.
The first thing SEC did was to make short selling legal by adopting Rule 10a-1 in 1937. Also called uptick rule, market participants were allowed to legally sell short sales of stock only if it happened on a price uptick from the previous sale, but short sales on down ticks were prohibited, with some narrow exceptions. The said rule also permitted short selling when the market was moving up, increasing liquidity and acting as a check on upside price swings.
Amid new legal and advantages of short selling, many policymakers, regulators, and the general public remained suspicious of this act. They found the ability to profit from the losses of others in a bear market unfair and unethical to many individuals.
In 1963, the US Congress ordered the SEC to evaluate the effect of short selling on subsequent price trends, which revealed the ratio of short sales to total stock market volume escalated in a declining market. In 1976, a public investigation into short selling was launched, seeking to test the outcome if Rule 10a-1 was revised or removed. In 1980, SEC withdrew its proposals because stock exchanges and market advocates disagreed with the proposed changes, leaving the uptick rule in place.
But the SEC eventually eliminated the uptick rule in 2007 after years-long of study, concluding the regulation did little to rein abusive behavior and it had the potential to limit market liquidity. Many other academic studies about the effectiveness of short selling bans also determined banning the practice did not moderate market dynamics. One year after, stock market decline and recession happened. Many pressed for greater restriction on short selling including constraining the uptick rule.
As of present, the SEC executed an alternative uptick rule, which is not applicable to all securities and is only triggered by a 10% or higher price drop from the previous close. Although the agency granted short selling legal status in the 20th century and stretched its franchise in the earlier part of the 21st century, some short selling practices were still legally questionable. For instance, in a naked short sale, the seller must find shares to sell in order to avoid selling shares that have not been affirmatively determined to exist. In the United States, broker-dealers are mandated to give reasonable grounds for their belief shares can be borrowed so these can be delivered on time before allowing such sale. Executing a naked short imposes the risk they will not be able to deliver those shares to whomever the receiving party in the short sale. Another forbidden activity is to sell short and then not giving the shares at the time of settlement, aiming to push down an asset’s price.
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