A mid intense market volatility, regulators around the world made the controversial decision to ban short-selling in certain stocks. These tumultuous times may now further alter regulators’ approach to short-selling rules.

The U.S. Securities and Ex-change Commission and Britain’s Financial Services Authority led the move to ban short-selling in certain financial services stocks in September, with regulators in other jurisdictions joining in, including members of the Canadian Securities Administrators.

At this point, it’s not clear what practical difference the bans have made. Stock prices continued to be very volatile throughout the duration of the bans — which expired in the U.S. and Canada three days after the bank bailout plan was passed in the U.S. In Britain, however, the ban continues until January.

Moreover, while the bans were designed to relieve pressure on financial services firms on the grounds that severe plunges in their stock prices can undermine counterparty confidence and erode the businesses of the financial services firms, a number of European financial institutions have collapsed. As well, several prominent U.S. firms came under enough pressure that they were forced into deals of necessity — even with the short-selling bans in place.

Superficially, it appears that the short-selling bans have made little difference, although it’s impossible to know how things might have been had they not been in place.

Besides, in Canada, the short-selling restriction applied only to a handful of financial services firms that are interlisted in the U.S. The move was made to prevent regulatory arbitrage only in those stocks. That left most of the financial services stocks in Canada open to short-selling — and some firms did complain that they were targeted in lieu of the firms protected by the ban.

But according to the Investment Industry Regulatory Organization of Canada’s analysis of its surveillance data, it found “no appreciable impact” on stock prices in either category of financial services companies — protected or unprotected — because of the short-selling ban. Although IIROC did observe lower volumes and increased volatility in the trading of both categories, there was no evidence of market manipulation or other major concerns.

Yet, these lower volumes and increased volatility have had negative effects of their own, say some market players. A monthly newsletter issued by alternative trading system Pure Trading reports that the restriction on certain short sales resulted in “a dramatic and costly decline in market quality for the Canadian inter-listed financial stocks.” The newsletter notes that unprotected financials maintained their typical trading spreads, whereas the protected stocks saw their spreads soar.

“More costly, from an investor perspective, was the complete lack of depth in the book,” the newsletter reports, adding that this lack of liquidity persists after the ban was lifted.

Although a decline in market quality affects all investors, one group that saw itself as particularly hit hard by the ban was fund managers — most notably, hedge fund managers, many of whom use short-selling as part of their strategy.

The early returns for the hedge fund industry show that they certainly did have a tough time during September. The Scotia Capital Canadian hedge fund performance index was down by about 11% for the month. The U.S. and global hedge fund indices didn’t fare much better: the RBC Capital Markets RBC hedge 250 index had a net loss of 7.7% for the month, the Credit Suisse/Tremont hedge fund index declined by 6.6% and the Greenwich Global hedge fund index was down by 4.9%.

Even though the overall market turmoil was surely the biggest reason for the weak returns, the ban on short-selling certainly didn’t help. Within the hedge fund universe, the ban probably hurt certain strategies more than others. The Credit Suisse/Tremont hedge fund index group points out in a report that the U.S. short-selling ban has affected hedge funds to varying degrees. Convertible arbitrage hedge strategies, for example, were hit hardest because managers were unable to hedge the equity portion of their convertible bonds, the report notes.

Indeed, convertible arbitrage managers fared the worst in the month of September across all three indices that break out returns by strategy. (The Scotia Capital index does not.) The convertible arbitrage strategy dropped by 21% in the RBC universe; it was down by 13.5% for the Greenwich funds; and it declined by 12.3% in the Credit Suisse/Tremont index.

@page_break@Despite the complaints that some market players have had with the effects of the ban, the events that led to it are, nevertheless, affecting how regulators think about their short-selling rules.

In mid-October, IIROC reported that it had received approval from the provincial regulators for a variety of technical changes to its trading rules. Those changes will provide IIROC with additional tools to address potential abusive short-selling and failed trade activities. A couple of planned changes, however, have been put off in view of recent market turmoil. Most significant, the Canadian market regulators were planning to follow the SEC in getting rid of price restrictions on short sales.

These changes had been planned following the results of a strategic review of the trading rules that IIROC’s predecessor, Market Regulation Services Inc., had initiated several years ago.

Based on a review of academic literature and input from the financial services industry, RS had concluded that these restrictions weren’t worth the trouble. RS’s initial rule proposal, published in September 2007, said the review of the academic literature “concluded that price restrictions typically act to restrict price discovery by limiting arbitrage and creating overpricing of securities, thus affecting overall market efficiency and liquidity.”

After the SEC did away with these price restrictions in the U.S. in mid-2007, Canadian regulators planned to follow suit. They had already adopted an exemption for interlisted securities, allowing traders to short such stocks without price restrictions.

However, IIROC has now decided to defer the plans to remove price restrictions on short sales for all stocks “because of the current market conditions,” it says in a recent report, “and the fact that the regulatory framework governing short-selling is under active review in the U.S. and other foreign jurisdictions.”

Indeed, some market-watchers have blamed the recent volatility in the U.S. — at least, in part — on the decision to do away with short-sale price restrictions there.

Instead of proceeding with that part of the proposal, IIROC’s report says, it will commission independent consultants to study the effects of the repeal on: price restrictions on interlisted securities that was adopted in July 2007; the effect of the amendments that have just been approved; and the possible effect of dropping all price restrictions on short sales.

The study will look at the impact of these factors on short-sale volume, trade failure rates, the ability to detect abusive or manipulative shorting, price volatility and market liquidity. It will also attempt to determine how these things are affected by periods of market stress.

The results of this research will dictate what happens with short-selling rules in Canada. IIROC indicates that there isn’t any single factor that will determine whether it goes ahead with a broader repeal of price restrictions or reverts to restrictions on interlisted securities. Although it does point out that if statistical trends — such as higher trade failure rates due to short-selling activity, or a big increase in trading alerts or short-sale investigations — would lead it to consider reinstating price restrictions.

An SEC decision to bring back price restrictions could lead Canadian regulators in that direction, as well. At least one SEC official has said that the U.S. regulator will consider reverting to price restrictions on short sales. But, so far, the SEC has not announced plans to do so.

In the meantime, changes to the short-selling rules in the U.S. are already driving planned amendments to the rules in Canada. IIROC reports that its board of directors has approved a proposed amendment to preclude additional short sales by a person who has executed a failed trade unless that person has arranged to borrow the securities — a proposal that is similar to a requirement being introduced in the U.S.

IIROC will publish its proposal for comment in the coming weeks. And, at that time, it will also issue a notice setting out the results of a statistical report on trends in the Canadian marketplace from May 1, 2007, to Sept. 30, 2008, that looks at overall trading activity, short-selling and failed trades.

Among other things, IIROC has found that there has been an increase in the proportion of short sales involving interlisted securities since the granting of the exemption from price restrictions in July 2007. There has not, however, been any other significant change in the pattern of short-selling. IIROC also notes that the rate of failed trades is declining generally and that “market stress” doesn’t appear to affect the rate or value of trade failures.

Nevertheless, the study that IIROC is proposing will look at these issues again, and over a different time period. IIROC says that it expects the study to cover the period from one year before these latest amendments were adopted to one year after they are in force.

The temporary ban on short-selling certain stocks was an emergency measure adopted in a time of immense market stress; lessons learned in these extreme conditions will now help guide longer-lasting rule reforms. IE