Regulation SHO: Preventing Naked Short Selling

Regulation SHO, a 2005 SEC rule, oversees short selling. Its purpose is to prevent naked short-selling by implementing "locate" and "close-out" requirements. In 2010, Regulation SHO was updated through changes to Rule 201. This amendment prohibits short-selling security if its price has dropped by 10% or more in a trading day, and it mandates that new bids must be higher than the current price.

Basics

Regulation SHO, implemented by the SEC in 2005, governs short-sale practices. It introduced "locate" and "close-out" requirements to prevent naked short-selling. Naked shorting occurs when investors sell shares they don't possess and haven't confirmed their ability to possess.

How Does Regulation SHO Work?

Short selling is when an investor borrows a stock, sells it, and later buys it back to return to the lender. They do this in the hope that the stock's price will drop. Broker-dealers lend securities to facilitate short selling.

To regulate short selling, the SEC introduced Regulation SHO on January 3, 2005, the first significant update since 1938. This rule includes a "locate" standard, requiring brokers to reasonably believe they can borrow and deliver the stock on a specific date before engaging in short selling. Additionally, the "close-out" standard imposes increased delivery requirements on securities with multiple extended delivery failures at a clearing agency.

Regulation SHO mandates reporting when the following conditions persist for five consecutive settlement days:

• The total fails to deliver at a registered clearing agency amount to 10,000 shares or more per security.
• The number of fails is equivalent to at least 0.5% of the total shares outstanding for that issue.
• The security is listed on an SRO-published list.

Regulation SHO Amendments

Close-out Requirements

Initially, there were two exceptions to the close-out requirement: the legacy provision and the options market maker exception. Concerns arose when these requirements were not met for failed delivery positions. In 2008, both exceptions were removed, resulting in stronger close-out requirements that applied to all equity securities. The time allowed for closing out failures to deliver was also reduced.

Rule 201: Alternative Uptick Rule

In 2010, further changes were made to address the issue of short selling being used to artificially lower a security's price. Rule 201, known as the alternative uptick rule, was modified to limit short sales' prices during significant downward price pressure on a stock.

When a stock's price falls at least 10% during intraday trading, Rule 201 is triggered. It mandates that short-sale orders must have a price above the current bid, preventing sellers from exacerbating a security's sharp decline.

Circuit Breaker

Under Rule 201, trading centers must establish and enforce policies to prevent short sales at impermissible prices after a 10% decrease in a stock's price within the trading day. This activates a "circuit breaker" that enforces price test restrictions on short sales for that day and the next trading day.

Exception to Regulation SHO

Short exempt orders, marked with the initials SSE by brokers, qualify for an exception to Regulation SHO. The main exception is the use of non-standard pricing quotes for trade execution.

Conclusion

Regulation SHO is a crucial SEC rule that regulates short-selling practices. It introduces "locate" and "close-out" requirements to prevent naked short-selling. The rule has been amended over the years, including the introduction of the alternative uptick rule and the circuit breaker. Short exempt orders qualify for an exception to Regulation SHO.