Big Board Hires Outside Sleuths to Look Into Problem : Who, If Anyone, Broke Rules on Short Sales?

From the Washington Post

Agatha Christie might have called it “The Mystery of the Short Sell.”

It is a puzzle so perplexing that a determined New York Stock Exchange has hired outside sleuths to try to crack it.

One part of the mystery is whether Wall Street’s program traders are violating stock exchange rules governing the controversial tactic of short sales, in which investors sell stock that they do not own. And the second part is why, if violations are occurring, the culprits can’t be found.

At different points in history both program trading and short sales have been linked with the manipulation of stock prices and blamed for contributing to market crashes. And in these situations, market officials have felt the need to take action, if only to retore the confidence of small investors and the general public.


Securities and Exchange Commission rules governing short sales are 50 years old, dating back to the wave of regulation that followed the Great Crash of 1929. Their purpose was to end an abusive trading practice known as “bear raids,” through which aggressive investors reaped tremendous profits by driving certain stock prices down.

Reversing a Strategy

When most individual investors think about the stock market, they think of buying a stock that they hope will go up in price. Their goal is to profit by buying low and selling high. Short sellers take the opposite approach, looking for opportunities to profit through a stock price decline by first selling high and then buying low.

They do so by telling their broker they want to sell a stock short, which means they want to sell a stock they do not yet own. They do so in the expectation or hope that the market price will decline and that they can then buy the stock at a cheaper price.


The amount of decline determines the profit to be made from short selling, and in down markets it can be substantial.

But after abusive short selling drove stock prices down in a manipulative manner more than half a century ago, federal regulators were determined to curb its abuse.

The result was the so-called “uptick rule,” which basically says that short sales cannot occur on the New York or American Stock Exchanges at a lower price than the previous trade. If the last trade was at $50 a share, a short sale can occur next at $51, but not at $49.

“From a public appearance perspective, short selling is perceived as un-American,” SEC Commissioner Joseph Grundfest said in explaining the political rationale behind the uptick rule. “When you sell short, you are in a sense betting against the team. At a minimum, it is an emotional issue.”


S&P; Index Popular

On Wall Street these days, emotion has turned to hysteria as short selling has been used as a critical linchpin for computer-directed program trading. In program trading, an investor executes simultaneous trades of stocks and stock futures contracts.

The most popular form of this program trading involves not individual stocks, but a basket of stocks--the Standard & Poor’s 500--for which futures contracts are traded on the Chicago Mercantile Exchange.

By itself, the S&P; index gives investors the opportunity to bet on the future movement of broad stock market averages. But Wall Street firms have now learned how to program their computers to constantly monitor the difference between the market value of the S&P; index and the current market value of the stocks that lie behind it. The process is called index arbitrage, and it is a form of program trading.


When the Standard & Poor’s 500 stock index futures contract, for whatever reason, begins to trade at a much lower price than the 500 individual stocks that constitute the average, Wall Street’s arbitrage computers automatically swing into action, ordering traders to lock in profits by simultaneously buying the futures and selling the stocks.

A Big ‘If’

The stock sales must be executed rapidly to assure that current prices are obtained, and therein lies the link between program trading and short sales. Frequently, the firms buying the futures and selling the stocks do not already own the stocks. Thus, they must sell the stocks short, often amid declining prices.

At times, more than 100 stocks are involved in the short selling. According to New York Stock Chairman John J. Phelan Jr., who spent many years on the floor of the exchange before moving upstairs, it seems implausible that so many short sales could be executed rapidly in compliance with the “uptick rule.”


After all, Phelan has asked, could so many stocks be sold in such a short period of time if all of them had to be sold at prices equal to or higher than the last trade?

The question is more than academic, for when program traders buy futures and sell stocks, waves of stock sales hit the floor of the NYSE and depress prices. Black Monday, Oct. 19, an astounding 25% of of all index arbitrage stock sales were short sales. On that day, wave after wave of sell programs hit the floor of the NYSE.

Troubled by that statistic and relying on his instincts as a trader, Phelan unleashed NYSE investigators to find violations of the short-sale rule in connection with program trading. If abuses were widespread, shutting down short sellers who violated the rules could dampen the volatility, and sudden stock-price plunges, associated with program trading.

NYSE Executive Vice President David Marcus said violators of the short-sale rule could be putting “downward pressure on the market which otherwise could not be there.”


Phelan’s suspicions did not cease when NYSE investigators went hunting for violators and came back empty handed. The exchange decided that a “fresh” look at trading records and other data was in order, so it took the unusual step of hiring outside investigators to pursue the hunt for short sale violators.

But there could be several reasons why outright violations and questionable circumvention of the rules could prove elusive.

According to sources, traders have developed strategies for concealing short sales that rely on the use of specially written stock options. (Stock options give investors the opportunity to buy or sell stock at a given prices on a future date.)

Hard to Detect


In addition, the SEC study October market collapse revealed that a “significant amount of index-related trading on Oct. 14 to 16 was effected off the NYSE, primarily in the London market through a special practice known as ‘EFPs’ or ‘exchange for physicals.’

“Investors seek at least two benefits from these EFPs . . . Short sales of millions of shares of stock can be effected in London (either before or after the NYSE session), arguably without violating Exchange Act Rule 10a-1 relating to short sales,” the SEC study said.

In other words, the absence of an uptick rule in London makes it possible for U.S. investment firms to avoid the U.S. rules governing short sales by trading American stocks in London.

Still another reason why short-sale violations may not be readily apparent is that some short sale trades may not be properly marked, sources explained.


With program trading in stocks and stock index futures highlighting the links between the stock and futures markets, some have asked whether a short sale rule could be extended from the stock exchanges themselves to major futures exchanges.

But officials of the Chicago Mercantile Exchange, where the largest stock-index-futures trading occurs, have said that their system of trading stock-index futures is incompatible with an uptick or short-sale rule. To institute such a rule, they have said, would require a complete--and impractical--overhaul of the exchange’s trading system.

The SEC study warned of the consequences of having stock and stock-futures markets playing by different rules.

Search Goes On


“The absence of short-sale restrictions in the (futures) markets, coupled with the greater leverage of futures, arguably presents the potential for greater speculative selling than could occur in the stock market. Moreover, through (program trading) that selling activity can be transferred to the stock market, often without being subject to” the short-sale rules, the study said.

Meanwhile, the NYSE’s search for violators continues even as program traders find ways to comply with the rules. Some make a practice of simply putting in orders to short stocks at slightly higher prices than the previous trades were executed. Others abide by the rules by adopting specialized trading techniques, including one tactic called “portfolio swapping.”

“They are complying,” said Jack Barbanel, senior vice president of Gruntal & Co., when asked about program traders and the short-sale rule. “If we had that problem, I think the SEC would have been right on top of it. If there are some problems, chances are they are minor.”

“I would assume at this point that if there was a real problem that the uptick rule was not being followed, it would have turned up,” said Jeff Miller of the New York-based program trading firm of Miller, Tabak & Hirsch.


Miller also pointed out that what appear to be short sales in connection with program trading may not be, since large Wall Street firms may, in fact, actually own the stocks they short on behalf of customers.

But the NYSE has not abandoned its quest. Amid the continuing short-sale probe and the debate over the impact of program trading, the Big Board last week began requiring member firms to submit daily information on program trading. The various studies of October’s collapse suffered from a lack of readily available program trading data similar to the large trader reports and other information produced in the futures markets.

Many Defenders

The NYSE also is working on a system that could lead to greater disclosure of the identities of investors in more routine trades.


Defenders of program trading--and there are many on Wall Street--say their brand of computerized trading makes a contribution to market efficiency by keeping the prices of stocks and stock index futures in line. When index arbitragers buy futures and sell stocks, for example, their trading can help to close the price gap.

To these true believers, the fear of program trading and its computers is nothing more than resistance to technology and change. But that is not the view of many investment firms that cater to individual investors and avoid stock index arbitrage--notably Merrill Lynch, which has remained critical of the computer-directed practice.