The ban on short selling and moral distinction in the markets: can algorithms play fair? (a few thoughts)

September 24, 2008

(Big thankyou to Zsuzsi Vargha for a very important idea)

The ban on short selling jogs the historical memory and ghosts of event of the post 1929 crash appear. During the post crash discussions in Congress, discussions that led to the creation of the SEC, the practice of short selling was blamed as one of the causes for the crash. Regulations controlling short selling were included in the 1934 Act, and a rule banning short selling sharply dropping markets (the ‘up tick’ rule) was implemented.

Naturally, not having a historical perspective on the current events in the markets does not help us in making direct comparisons. However, when we examine the SEC’s press release announcing the ban, the fundamental regulatory worldview underpinning the move become visible and with it, the connections to the 1929 crash, the constitutive event of the SEC. For example, market makers and specialist will be exempt from the short selling ban. Market makers provide liquidity to the markets. Hence, it is little wonder that in such a move, intended to prevent illiquidity, market makers will be allowed to continue selling assets short. However, a closer look shows that not all market makers would be entitled to these exemptions: “we are providing a limited exception for certain bona fide market makers.”

The distinction implied above, between ‘bona fide’ liquidity-supplying, short-selling market makers and between risk-takers intensifies the connection between the early 30s of the last century and the event of last week. The connection does not stop at the actual ban on short selling, but goes much deeper. In fact, it touches some of the deepest roots that connect American culture financial markets: the ambiguity surrounding risk and moral behaviour in financial markets. This connection can be expressed in the following moral dilemma-type question: under which circumstance can risk taking can be considered acceptable, and under which should it be condemned?

The answer that emerged from the discussions leading the creation of the 1934 Act aimed at defining the moral boundaries of market behaviour: risk taking would not acceptable when the only motivation behind it is greed and when the consequences of such behaviour may affect adversely others. Anyone vaguely familiar with financial markets would see the inherent problems of this definition. First, greed is a major motivation in financial markets. It is not only accepted but also, in effect, celebrated there. Penalizing greed in the market would be equal to giving speeding tickets at the Indy 500 (as was mentioned in a different context). Second, in the market there are countless situations where one’s actions affect negatively the wellbeing of others. In fact, the fundamental practice implied in stock options is of a zero-sum game: repeat bets on the price of the underlying asset where one’s gain equals exactly to another’s loss.

The above definition and its inherent difficulties have a long regulatory history. Obviously, this cannot be unfolded here, but a good place to start would be to trace the SEC’s releases related to rule 11a1-3(T) of the 1934 Act, a rule that defines and govern the conduct with regard to bona fide hedging. The history of this rule, which is a dimension in the history of moral behaviour in markets, provides us with a basis for comparison between the current market environment and between the one that existed the last time a comparable ban on short selling existed – in the 1930s. While in the 1930s, traders were the ones demanded to internalise and activate the moral code of conduct, today this demand is directed at a much more diversified group of market participants.

That group, among others, includes programmes and network experts who design and operate trading algorithms. The exact figure is not known, but it is estimated that about 30% of the short selling transactions in SEC-regulated market are conducted through such algorithms. This is not simply a ‘technical matter’ of programming the new requirement into the Direct Market Access ‘boxes’, as they are nicknamed. So, while the set of normative demands related to bona fide hedging can be understood, debated and followed in a meaningful manner when we are dealing with human market makers, what meaning would it have when machines are expected to behave morally?

10 Responses to “The ban on short selling and moral distinction in the markets: can algorithms play fair? (a few thoughts)”

  1. danielbeunza Says:

    Your post about the shorts is fascinating. If I can try to summarize it, Yuval, your point is that regulating the shorts mixes two different “regimes of worth”, ethics and the market. And that the mix of the two makes for an inconsistent rules, in which some actors (humans short selling investors) cannot short, and others (algos, human investors who merely want to hedge) can. I agree… it is inconsistent.

    Let me add some more thoughts. First, what does shorting mean from a Social Studies of Finance perspective? Here, my view is informed by my conversation last Sunday with Harrison Hong. The market, in the SSF view and in Harrison’s own view (“differences of opinion” paradigm) is a forum for resolving controversy. Eliminating the shorts will hamper the dialogue by silencing one of the sides to the argument.

    Here, however, is my counter-argument. For practical reasons, forbidding short selling just now may be the right thing to do. The reason is that the market is a social entity, given to self-fulfilling prophecies and other types of vicious cycles. Specially acute is the effect of mark-to-market and the relationship between stock prices and credit rating.

    Second, are the shorts acting out of their own estimates of value, or are they trying to game the system? This past Monday I went to a panel to listen to Bill Ackman, a celebrity short. His sharp (almost too sharp) response to an academic question of mine “go back to your research” led me to think that there’s a lot going on here. This was further reinforced a few days later, when I heard from a friend who works at Citi that shorts have developed a sophisticated system for coordinating their “attacks” through instant messaging. Now, obviously, this is just a rumor. But the possible presence of material devices that might (and I don’t know how) help solve their coordination problems suggests, again, that there may be more than meets the eye.

  2. typewritten Says:

    Technical question: how does this ban interact with the Investment Company Act of 1940, especially the parts that opened the path to the hedge fund “anomaly” (i.e. their existence on the sole basis of being limited to “sophisticated” investors and being allowed to do the short-selling thing)?

  3. yuvalmillo Says:

    To typewritten,
    Very good question. I really don’t know the answer and I must say that I don’t know the 1940 Act well enough to understand how the exemptions from the short-selling ban would affect it. However, from what I do know about hedge funds, it would seem to me that not going short is virtually an impossibility for many of them. I mean, there is a trading strategy called ‘long-short’, which is based taking long-short positions. I can’t imagine hedge funds that run this strategy changing their mode of operation or going out of business. In a more general note, it would be very difficult for the SEC to define and detect short sales in a meaningful way if the lender of the stock would not report the borrowed stocks.

  4. typewritten Says:

    An interesting, critical paper here about the regulation of short selling (the author works on regulatory controversies about hedge funds):

  5. danielbeunza Says:

    Very interesting article. Thank you. Reading it now. By the way, there’s also the book by David Einhorn, the short seller that attacked Lehman for a year:

  6. panik Says:

    It seams to me that before being able to say anything about morality or knowledge claims in relation to short selling, it is important to deal with the question Yuval raises regarding asset lending that relates to the logistics of market operations such as settlement and market making vs. short selling for the purpose of making gains from speculation. It is in fact where the two blur that the real action is.

    Some ‘clever’ guy who was acting as a kind of spokesman on the UK media defending the hedge funds and short sellers in relation to the collapse of HBOS in the UK, whipped out from his pocket a printout of the stock lending data from CREST, the UK securities settlement system, and pointed to the figures for HBOS on the day the share price dropped off a cliff and that – unsurprisingly – showed that there was little difference in the stock lending figures for HBOS shares than most of the others that day and that this figure was in any case a tiny proportion of the share capital of the company. That was of course true. While studying CREST, I had downloaded the same pdfs. It is no big deal. The link is:!ut/p/c1/04_SB8K8xLLM9MSSzPy8xBz9CP0os3gz08BgH3MPIwMD3wAXA6MQIwNP04BgYwtPM_1wkA48Kgwg8gY4gKOBvp9Hfm6qfkF2dpqjo6IiAEKz98I!/dl2/d1/L2dJQSEvUUt3QS9ZQnB3LzZfNjVRU0w3SDIwMDVUMjAyMzYwSTVWTTBSNjU!/

    Anyone can get these stats. This, however, is not the issue. This is the lending that takes place among the participants in the settlement system for the purpose of making the settlement system work and without it, the marketplace would seize-up. This is not where the shorting takes place. The lending relating to shorting takes place one level up from there.

    Because this kind of industrial scale of transaction processing has both high fixed overheads and also requires industrial size working capital (both cash and securities) to do at a level that is profitable, many market participants (including smaller and even medium size brokers as well as funds, institutional investors, large corporations etc) outsource the management of their assets to what are called here in the UK, prime brokers.

    By aggregating all the large, medium, and small holdings of assets that their clients entrust them with to manage, prime brokers are able to use the pools of liquidity for pretty much any tradable asset they thus accumulate to lend these assets, for a fee, to any of their other clients to use in whatever trading strategy they might see fit to pursue. And since the assets that might get depreciated in the process are of another client and not their own, the prime broker has nothing to loose and all the fees for the lending to gain.

    Prime brokers also make possible trading anonymity because they typically allow clients the choice to execute transactions either in their own name or under the name of the prime broker, whilst the settlement of these transactions occurs in the name and under the responsibility of the prime broker.

    Through their trade-processing services prime brokers are able to aggregate customers’ collateral and thus be in a position to provide the credit risk management and asset lending services so crucial to hedge funds and aggressive trading strategies such as shorting.

    Where is the bundary between legitimate market makers, settlment system participants who bulk process trades for others, and prime brokers? Furthermore, how can you stop them internalising the lending mechanism?

  7. yuvalmillo Says:

    Panik: many thanks for the post! Clearing and settlement, the ‘plumbing’ of the financial world are not well researched and understood outside a small community of professionals. This is definitely an issue for SSF, with its strong actor-network roots, as it one of the most machine-centric areas of finance, if we can put it this way. In fact, with the dispersion of algorithms to every corner of the financial world, social studies of clearing and settlement may be on the forefront of research.

  8. danielbeunza Says:

    I confess I did not understand Paniks’ comment. Panik: in a nutshell, what is your point?

  9. panik Says:

    Shorting depends on securities (and/or other assets) lending. This lending, however, is an integral part of the marketplace mechanisms concerned. Without it most financial marketplaces would not function properly or function in a very costly way. There are market participants (e.g. prime brokers) who span these two worlds and who act as a kind of bridge between “good” (according to the new regulatory climate) securities/assets lending that enables the marketplace to function and “bad” securities/assets lending that fuels speculation and aggressive trading strategies such as shorting. Without this intermediation/translation made by these entities, shorting would not be possible for a number of reasons I can discuss further if required. It is these intermediaries that enable hedge funds by providing the mechanisms that make possible not only asset lending but also anonymous trading and credit/counterparty intermediation. The back office and transactional logistics aspects are just as important to the innovation of hedge funds and aggressive trading strategies as economic models and new economic understandings. Without the ability to concretize an aggressive trading strategy or perform a new model through actual transactions, it would remain an interesting theory but little more. The problem the regulators now face and which I think will be very difficult to resolve (and which Yuval also hints at) is how to make the fuzzy boundary between “good” and “bad” securities lending into a line, especially since this line in likely to run “through” key market participants rather than “around” them.

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