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?