Business Insider

Crabb: Making short-selling harder will bolster investor confidence

The traders are finally getting their say.

On March 6, I had the opportunity to take four of my students on a visit to the floor of the New York Stock Exchange.

A long time floor trader for Smith Barney was our guide. He spent a good part of our visit discussing a big problem initiated by the U.S. Securities and Exchange Commission in the summer of 2007.

The SEC was created after the Crash of 1929. It is charged with overseeing all participants in the market for financial securities, including exchanges like the NYSE, brokers, dealers, and mutual funds.

The SEC must promote disclosure of all important information and maintain fair dealing among the participants.

After strong cries from traders, the SEC is now taking public comment on a proposal to reinstate the "uptick" rule, abolished in 2007 just about the time the current financial crisis began. The rule states that a trader cannot initiate a short sale unless the price of a stock for the last trade is higher than the price for the previous trade.

Short selling, or borrowing shares and selling them in the hope prices will fall, is used in large part by hedge funds and other active stock traders. Our guide described how much the mood in the market changed when the rule was removed two summers ago.

In July 2007 many traders increased the extent of short selling on bank stocks. This downward selling pressure made it harder and harder for banks to raise capital.

The Standard & Poors Banking Sector index traded at 37 in late June 2007. Today, the index is around seven, an 81 percent drop. Over the same period average daily trading volume has increased tenfold.

A large increase in short selling also occurred at the time of the 1929 stock market crash.

Establishment of the SEC was thought to prevent such large market swings.

Reinstatement of this rule will give the market a big shot of confidence. Knowing that short sellers can only make their move when prices are rising reduces the risk of holding, or buying more of, beaten-down stocks.

The stock market rallies of recent trading days are sure signs that any move to make short selling more difficult is a positive sign for investor confidence and perhaps a turn in this unprecedented market downturn.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.