SEC Tools to Halt Panics Include Banning Shorts, Shutting Market
SEC Tools to Halt Panics Include Banning Shorts, Shutting Market
(Bloomberg) -- The coronavirus-fueled sell-off for stocks is prompting traders to ask what else regulators can do to intervene in cascading markets.
If the carnage worsens, the U.S. Securities and Exchange Commission and other financial watchdogs around the globe could conceivably step in and take more extreme measures. These include banning short selling, imposing stricter halts in trading of companies whose shares suffer precipitous falls and, though it would be a radical measure, shutting down stock markets.
Wall Street has a bit of a love-hate relationship with such tactics. Many industry executives consider them an unnecessary intrusion in the markets and question whether they actually work. Some even argue the moves can exacerbate slumps by making already nervous traders even more anxious.
But Wall Street embraced regulatory intervention during the 2008 financial crisis. Bank leaders started fretting that their cratering share prices could contribute to runs on their firms, with clients and depositors potentially pulling funds en masse from seemingly teetering institutions. Bank chief executive officers weren’t shy about expressing their concerns to regulators, who ultimately banned bearish bets against almost 1,000 financial stocks. It was a highly questioned and scrutinized decision.
With markets again sliding, here’s an overview of the weapons regulators have in their arsenals to fight back:
Circuit Breakers
Circuit breakers were introduced in the U.S. after the Dow Jones Industrial Average plunged 23% on Black Monday in October 1987. They trigger a timeout from trading after prices tumble by a predetermined amount.
The market wide circuit breaker for the S&P 500 works like this: If the index falls 7% intraday, trading is paused for 15 minutes. If trading restarts and the index then falls by 13% from the previous day’s close, trading is halted for another 15 minutes. If the decline hits 20%, markets close for the day.
Following the 2010 “flash crash,” in which stocks plunged almost 10% in minutes before quickly recovering, trading limits were implemented for individual securities. The current restrictions, known as limit up and limit down, aim to curb stocks from mistakenly trading outside of specified price bands. As a result, stocks can’t be quoted 5% lower or higher than their average reference price in the preceding five minutes for most of the day. If no trades can be executed within that band, then trading is halted for five minutes.
Presumably, regulators could tighten these safeguards to respond to coronavirus.
Proponents of circuit breakers argue they can slow sell-offs and help restore market confidence. But getting them right isn’t easy. If the pauses are set too wide, they’re rarely triggered. And too narrow of pauses can lead to frequent, unwanted stoppages. The bigger upshot: it’s unclear whether circuit breakers actually remedy panic selling.
Banning Shorts
The SEC’s September 2008 decision to temporarily prohibit short-selling of financial stocks wasn’t made lightly and came amid intense pressure on the agency from the Federal Reserve and Treasury Department.
Wall Street was rampant with speculation that hedge funds were engaging in manipulation by betting against banks and then spreading falsehoods that the firms were close to insolvency. John Mack, Morgan Stanley’s then CEO, sent a memo to employees at the time arguing that the market was “controlled by fear and rumors.”
In a 2013 paper, Harvard University researchers argued there’s little evidence that the ban lifted stock prices. In drawing that conclusion, they noted that the SEC announced the prohibition on the same day that there was a much more important catalyst for bank stocks -- the Fed and Treasury revealed that they were working on a plan to bail out Wall Street.
Companies that were later added to the SEC’s list of shares for which short selling was banned never experienced a price bump as a whole, the Harvard academics wrote. In fact, these companies had negative returns.
Shuttering Markets
Market closures are rare -- U.S. trading was shuttered for two days in October 2012 due to Hurricane Sandy and for a week after the Sept. 11, 2001, terrorist attacks. Trading was never suspended during the 2008 financial crisis, a sign of how hesitant regulators and exchanges are to do so.
Based on precedent, coronavirus is more likely to cause a market closure because it’s preventing financial industry employees from getting to work than because it’s spurring a prolonged market slump.
Uptick Rule
For decades, traders were prohibited from short-selling U.S. stocks until their prices experienced an uptick. In other words, if every price that a stock traded at was lower than the preceding trade, then a market participant couldn’t ever bet against it.
In 2007, the SEC did away with the uptick rule after determining that it didn’t prevent manipulation but did reduce market liquidity. There were also serious questions raised about whether the regulation still made sense in the era of lightning-fast electronic trading.
When stocks tanked during the financial crisis, many on Wall Street and in Congress partly blamed the removal of the uptick rule. So in 2010, the SEC brought the regulation back in a modified form. In the new version, short selling is restricted if a stock falls 10% from the previous day’s close. When the 10% threshold is triggered, traders can only execute short sales at a price above the market’s best bid, and the curb is in place through the following trading day.
Some traders, including legendary money manager Leon Cooperman, are known to argue during market downturns that the SEC should re-institute the original uptick rule because doing do will reduce volatility.
That seems unlikely to happen. Brett Redfearn, the official who runs the SEC division that oversees stock trading, told CNBC in a December 2018 interview that the uptick rule didn’t work.
--With assistance from Ben Bain and Nick Baker.
To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net
To contact the editors responsible for this story: Jesse Westbrook at jwestbrook1@bloomberg.net, Gregory Mott
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