Gradient Insights: Some thoughts regarding the SEC’s proposed short selling rule

Ian Striplin  by Ian Striplin
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

The very nature of borrowing shares, securities lending, and short selling is opaque. During recent equity events, existing reporting procedures exacerbated the misperception of short interest levels and influenced the intentional short squeeze mechanics. Without rehashing what has been discussed at length, written about, and even chronicled in film, the SEC has been put in a difficult – but not unmanageable – position to “do something” about nefarious practices among some powerful short sellers. As a result, the SEC is proposing Rule 10c-1 under the Exchange Act, which would require any person who loans a security on behalf of itself or another person (Lender) to provide the specified material terms of their securities lending transactions to a registered national securities association (RNSA).

While the proposal impacts many asset classes, the securities lending market is dominated by US equities, and we focus on those impacts here at Gradient Analytics. Our clients look to us for differentiated short ideas built on a foundation of earnings quality concerns. Along with other liquidity measures, Gradient has always been mindful of short interest, not only to avoid crowded short trades but also to provide fresh ideas to our institutional clientele. If anything, we believe our research will stand to benefit from increased transparency, which demands greater effort to find actionable short ideas.

There are many items on SEC chairman Gary Gensler's agenda, and this may simply be the “topic of the day.” Indeed, we believe the short-seller bogeyman fits well with other recent demands – including a congressional stock trading ban, forced ESG investment, and T+0 (i.e., same-day) settlement of security transactions. In the interim, we looked at the proposal and came away with several thoughts, many of which one also might find in the comment section of the SEC website.  Read on…

While it appears that most of the reporting constraints of the proposed SEC Rule 10c-1 would be implemented at the lender level, we believe the primary impact on short sellers will be a higher borrowing rate. The SEC disagrees, stating that the "Commission preliminarily believes the proposed rule would also likely reduce the cost of short selling, leading to improved price discovery and liquidity in the underlying security markets" (Proposed Rule: Reporting of Securities Loans). However, later it also notes that "costs may be absorbed by the entities that provide 10c-1 information to an RNSA [registered national securities association] in the form of lower profits, or they may be passed on to the end customer in the form of increased fees for broker-dealer services or lending program services." The Commission estimates that lenders would collectively pay about $375 million in initial costs and $140 million on an annual basis going forward. We believe those real regulatory costs ultimately will filter down to the cost of borrow.

With the thrust of this effort being increased transparency, the SEC has proposed a near-real-time reporting structure through FINRA. The proposal would require lenders to report activity within 15 minutes, with the data compiled and published on a regular interval (likely daily). Under the current reporting regime, in which data is published twice a month, the applicability and accuracy of this information is in question. In fact, the delay in reporting has created an opportunity for data providers that charge for access to securities lending information. Within the give-to-get securities lending data stream, information is often rolled into a larger service offering. The structure and closed (but incomplete) data availability lends itself to an unwillingness to evolve from the free market side of this equation. The proposal addresses this factor as well, pointing out that "the proposed Rule would render existing securities lending data less valuable, leading to less revenue for the firms currently compiling and distributing this data.”

The main concern with the proposal is a risk of a short trade becoming crowded and exposed to a short squeeze. It is not uncommon for a short position to take days to put on such that it could be more quickly identified and exploited. Although the proposal also calls for greater granularity, outside of the names of the borrowers, "the collection of information is expected to be, for the most part, publicly available information.” Even without disclosing the names themselves, daily reporting requirements can be used to enhance visibility into a rapidly placed short position – and even identify the fund, depending upon the target and activist nature of the short seller. On one hand, this severely limits the number of potential traders who would be capable of entering/exiting short positions. On the other hand, it may increase close followers looking to ride another firm’s positioning. In either case, the concern is that a potential short squeeze may be initiated by bad actors or as a result of weakness in other parts of the fund’s book leading to a wider array of threats to any short strategy.

One of the key disclosed data points is the borrow rate, which has varied widely and appears to rise steeply as available shares become scarce. For example, the proposal points out that "stocks at the 90th percentile of lending fees have an average lending fee of 7% per year while the median stock has a lending fee of about 0.6% per year" (SEC). The proposal, as written, combines both 1) rates to traders from brokers and 2) rates from large shareholders to brokers, which may have additional relationship considerations outside the security in question and impact its cost of borrow.

In the end, we believe that whatever the SEC brings forward, if anything at all, will likely raise the cost, lower the availability, and increase the risk of short strategies. Perhaps that’s its ultimate goal. In addition, we believe that more up-to-date securities lending data will increase the need for differentiated short ideas that have not yet been appreciated by other market participants. We look forward to hearing the comments from market participants and tracking the progress of regulators on this topic.

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any opinions, commentary, rankings, or stock selections provided by Sabrient Systems or its wholly owned subsidiary Gradient Analytics. Sabrient Systems makes no representations that the techniques used in its rankings or analysis will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results. 

Earnings Quality