Short-Attack: Whose Market Is This Anyway?

April 14, 2009

All eyes are on the SEC's review of short-selling rules. Let's just hope they leave ETFs alone.

If you step up to a boisterous craps table in Las Vegas—the kind with cheering and free-booze laughter and flying chips—you can be sure the table is going one way: Someone's rolling points.

If you proceed to drop a big stack of chips on the "Don't Come" line, daggers will fly from the bettors' eyes and you'll be a pariah. And if the luck should go your way at the expense of all those at the table rooting for the shooter, they'll turn on you like a pack of savage dogs.

That's the world of the short seller.

The quick headline has been that the SEC is looking at reimposing the uptick rule—an antiquated system where you could only short a stock if it had just traded up. The rule was wiped out in 2007 for good reason: The introduction of decimalization made the idea of waiting for a single trade up just a penny ludicrous, something that would simply be gamed by even moderately savvy market participants.

The reality of the proposed changes is far more complicated, and it's worth wading through the actual proposed changes to reg SHO—all 247 pages of them. They ultimately boil down to two things:

  1. Either reinstate some version of the uptick rule, or
  2. Institute single-stock circuit breakers, preventing short-selling of a stock in free fall

It's probably safe to assume that some version of these proposals will come to pass, and the fact that the major exchanges haven't objected makes it nearly a foregone conclusion. But it's interesting to note that Joseph Mecane, NYSE Euronext's EVP, is saying "but not for ETFs," according to Reuters (via CNN).

Personally, I think a rigorous price-test uptick rule is just an opportunity for more-sophisticated players to profit while the average Joe gets poor execution. Of the proposals on the table, I think the single-security circuit breakers make the most sense.

But with the advent of some new rule—my preferred version or not—life will get very interesting for the makers of leveraged and inverse ETFs like Proshares and Direxion. These funds have democratized trading techniques that were once the sole province of institutions and large, sophisticated individual investors. If ETFs were not exempt from these rules (and it's worth pointing out that they've historically been exempt), how exactly would the implied arbitrage between ETFs that act as de facto pairs work?

If the Nasdaq-100 is down 9% intraday and you think it's going lower, you can take a short position in the Invesco PowerShares QQQs (NYSE Arca: QQQQ), or you can go long the ProShares Short QQQ (NYSE Arca: PSQ). But if ETFs are bounded by circuit breakers or require an uptick to short, what happens when the Nasdaq 100 is down 11% on waterfall trading? Well, presumably those PSQ shares are still in the open market, but you can't short the QQQQ even if you wanted to. This discrepancy would inevitably show up in a short-term widening of the spread.

And of course, if you're the counterparty to the swap underneath the inverse ETF, your ability to hedge just got a lot more complicated, too.

Rules for individual stocks? I can see the reasoning. But rules for baskets—notional baskets at that—just don't make sense.


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