Paredes Urges Caution in Regulatory Response to Market Events

Commissioner Troy Paredes discussed the pros and cons of short selling and the uptick rule in a recent speech to the Securities Traders Association. Paredes noted that investor confidence is one of the rationales given for implementing a short sale restriction, but urged caution in acting on that basis. He described circumstances in which the decision to implement a short sale restriction may have the opposite effect, even if the restriction is initially welcomed.

Paredes said the SEC is considering whether the decision to repeal the uptick rule in 2007 left a gap in the regulations governing short selling that should be filled. When the SEC repealed the rule, it did so based on a careful empirical analysis and a pilot program which provided data for the study on the impact of the rule change. Whatever the SEC decides to do with regard to the uptick rule, Paredes said its actions must be based on independent expert judgment.

Paredes said the SEC, as a matter of policymaking, must assess the potential for abuse and manipulation in comparison to the benefits of short selling. Paredes also pointed out that short selling is not unregulated. The SEC last year adopted rules relating to naked short selling. He added that the repeal of the uptick rule should not be blamed for naked short selling.

Paredes believes it is appropriate to consider whether to reinstitute a short sale restriction, but said the economic finding which supported the SEC's decision to repeal the uptick rule may still hold true. Paredes said he is unaware of any empirically-demonstrated link between recent market conditions and the repeal of the uptick rule.

Paredes suggested that expectations should be modest with respect to how much investor confidence may rise if the SEC adopts a short sale restriction. The lack of investor confidence may be primarily due to the recession and other economic stresses, he said, rather than the lack of an uptick rule.

Paredes expressed concern about "ratcheting" up the short sale restriction if once it is adopted it does not achieve its intended goals. The restriction must not become too restrictive and costly to the markets, he said.

Paredes said one benefit to the circuit breaker, rather than the price test approach, is that a circuit breaker does not affect short selling until there is a steep and quick price drop. However, a circuit breaker may create the so-called "magnetic effect," in which it accelerates selling pressure as a company's stock price approaches the trigger point. A circuit breaker may also create an adverse psychological impact on the markets.

No alternative is without risks, Paredes advised. The SEC must consider the range of possible outcomes associated with the rule proposals it has issued for comment. If the SEC chooses to adopt a short selling restriction, he said the right set of exclusions will be key to reducing any undesirable consequences.

Paredes also addressed the many references to regulatory gaps that must be closed. Paredes said that gaps are not the right way to frame the issue since many gaps are purposeful. Some gaps reflect an informed decision not to regulate in the best interests of investors and the economy. He offered the Investment Company Act as an example, which is reasonable because it does not subject every fund to its demands.

Hedge funds, private equity funds and venture capital funds are structured around the exclusions in the Act. Paredes said the denial of this flexibility would be costly. He is concerned that features of the regulatory regime that are flexible and allow innovation and growth may be considered gaps that should be closed. It is essential not to overreact to recent events, according to Paredes. Change is needed, he said, but so is caution. It is possible for the government's response to do more harm than good, he said.