The pendulum swings
21 January 2020
Last year saw questions raised around the place of ethics in financial markets, with the practice of short selling, in particular, put under scrutiny. Now, a Canadian lobby group is calling for tighter regulations on the practice and it has already had some success
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A storm of securities lending- and short selling-related news caught the financial world’s attention late last year and prompted a fierce debate around the role ethics should play in investment strategies and regulatory oversight.
The war of words was sparked in December 2019 by the world’s largest pension fund, the Government Pension Investment Fund (GPIF) in Japan, when it announced it was shutting down the foreign equity portion of its securities lending programme. It claimed that a lack of clarity around who the end borrower was and what they would use the asset for was at the root of its concerns.
In response, Elon Musk, the CEO of Tesla, an electric car maker and prolific short target, waded into the online debate around the ethics of short selling and called for the practice to be made illegal. Musk applauded GPIF’s decision by writing to his 29.9 million-strong online following: “Bravo, right thing to do! Short selling should be illegal.”
In terms of global regulators’ take on the practice, sentiment ranges from active encouragement to low-key hostility. That said, the past few years saw a series of Asian, Middle Eastern, Latin American and African market regulators actively developing their rulebooks to boost securities lending and short selling activity. For example, Argentina lifted its short selling ban in April 2018, and the Asia Securities Industry and Financial Markets Association proposed a workable securities lending regime in China in March last year that would also facilitate short selling.
Elsewhere, the European Securities and Markets Authority also published a report shortly after GPIF’s announcement to plant its flag squarely on the side of securities lending and short selling.
The EU watchdog concluded an investigation into “undue short-term pressures in securities markets,” which dismissed concerns from certain quarters of the financial market that securities lending and short selling were not compatible with environmental, social and governance (ESG) aims.
However, as has ever been the case with debates around short selling, for every argument won somewhere in the world, another is being lost.
A war on many fronts
While most interested parties’ attentions were fixed on the discontent in Asia, the debate around appropriate oversight of short sellers was also flaring back to life half a world away, in Canada.
A lobbying group named Save Canadian Mining (SCM) is currently fighting for Canadian stock exchanges to re-introduce a form of ‘tick test’, sometimes known as the ‘uptick rule’, for stock in the country’s junior markets.
A tick test requires short sales to be conducted at a higher price than the previous trade, with the idea being that you wouldn’t be able to overwhelm the market and put unreasonable downward pressure on stock prices.
Up until 2012, all Canadian exchanges featured a tick test for short selling, but it was removed following the publication of market research in the US that it was not an efficient method of stopping the type of short selling pile-on that it was created to mitigate against. The US also scrapped a similar rule based on the same findings, but subsequently brought it back in a modified form.
The argument being put forward by SCM is that although the removal of the tick test has helped Canadian markets evolve in a macro sense there is now a dynamic where short selling activities, high frequency trading, and algorithms are exploiting the lack of a tick test to the detriment of Canada’s junior markets.
However, for Canada to also reintroduce a form of tick test, Canada’s self-regulatory organisation for the investment industry, the Investment Industry Regulatory Organization of Canada (IIROC), has said that all 14 exchanges must agree on the benefits of doing so and present new evidence to back up the move.
“IIROC’s decision to repeal the tick test restrictions in 2012 was based on studies we had conducted which demonstrated that the tick test had no appreciable impact on price movement,” a spokesperson for the regulator explains. “Although we are not re-evaluating the tick test at this time, we would consider it in light of any new empirical evidence.”
So far, concrete new evidence has not been forthcoming, although anecdotal evidence has suggested that the unilateral removal of the rule has had a disproportionately negative effect on Canada’s junior markets, specifically in mining, technology and fintech sectors due to their limited stock liquidity. Hence the formation of SCM.
Nonetheless, SCM has gained the attention of Canada’s TSX Venture Exchange (TSXV), which has confirmed it is considering re-introducing a version of the tick test that would restrict traders to only shorting a stock if it was on an upward trajectory.
The proposed rule would apply to stocks of companies in the ‘junior markets’, meaning listed companies under CAD 250 million (US$191.22 million), and would give a floor and ceiling to short selling.
Brady Fletcher, managing director, head of TSXV at TMX Group explains that the exchange is also pushing for IIROC to refresh its failed trade study and take a more holistic look at market structures for these junior issuers.
Fletcher adds that conversations are being had around whether reinstating the tick test is appropriate or if it makes more sense for venture listed companies to only trade on one market.
In this vein, Fletcher explains that the increasing number of exchanges and alternative trading systems creates issues when it comes to updating or overhauling market rules.
“It does create a challenge for us because we cannot go and make changes or test things out that we think could potentially benefit smaller or more illiquid issuers,” he says. “We need to question whether having 14 trading venues makes sense when you’re a company that trades by appointment, or does that end up fragmenting liquidity. What we really need to do in Canada is see where we can change and where we can improve.”
Ace in the hole
Despite a slow start, those seeking to impose stricter rules on short sellers on Canadian exchanges do have a trump card: the fact that the US re-imposed a form of tick test a few years after it repealed it, coupled with the precedent that Canada and the US markets are inclined to lean towards continuity and following one another.
The tick test made its first debut in the US in 1938 and remained until 2007. Canada then followed suit in 2012 when it was removed by IIROC.
But, in 2010, the US Securities and Exchange Commission (SEC) approved rules that would require the country’s exchanges and the Financial Industry Regulatory Authority (FINRA) to pause trading in a stock if the price drops 10 percent or more in five minutes.
The rules, which were proposed by the national securities exchanges and FINRA and published for public comment, came in response to the infamous “flash crash” of 6 May 2010, according to the SEC.
The crash saw the prices of many US-based equity products experience rapid decline and recovery in a single day, demonstrating the impact of high-frequency traders.
Speaking in June 2010, then SEC chair Mary Schapiro, who convened a meeting of the exchange leaders and FINRA at the SEC following the market disruption, said: “The 6 May market disruption illustrated a sudden, but temporary, breakdown in the market’s price-setting function when a number of stocks and exchange-traded funds were executed at clearly irrational prices.”
“By establishing a set of circuit breakers that uniformly pauses trading in a given security across all venues, these new rules will ensure that all markets pause simultaneously and provide time for buyers and sellers to trade at rational prices,” Schapiro added.
Discussing the US’ alternative uptick rule, TSXV’s Fletcher notes: “During the financial crisis both Canada and the US banned short selling in certain financial institutions. Following that, the US put in the alternative uptick rule, which meant that if a stock was already under pressure – i.e they have seen a 10 percent share drop in one day – then it gives the long holders the ability to jump to the front of the selling queue.”
Fletcher adds: “Therefore, the title of calling it ‘the alternative uptick rule’ is really a bit of a misnomer because what it does is give long holders of stocks a preference to sell in their position before the shorters can continue to put negative pressure on a stock.”
Elsewhere, the US now also boasts a clear and prescriptive pre-locate rule, which means that anybody looking to go short in the US has to be able to prove where their borrow requirement was coming from. “Now, in Canada, we have something similar but it is a bit more of a commercially reasonable effort,” Fletcher explains. “The Canadian rule says that we have to have a ‘reasonable expectation’ of finding that borrow requirement at the time of completing the short sale.”
The IIROC spokesperson explains that its real-time market surveillance activities include monitoring for extreme price movement both up and down regardless of whether a short sale or otherwise.
According to IIROC, single-stock circuit breakers automatically halt trading for five minutes when a covered security’s price moves up or down beyond a specified threshold.
A game of groans
TSXV and groups like SCM have brought further debate to the table regarding short selling. And, as well as the tick test, SCM and TSXV have initiated a conversation on the market structure as a whole, which the exchange says needs to be looked at deeply to see what it should look like for entrepreneurs trying to access public venture capital.
However, considering IIROC requires new research favouring the reinstatement of the uptick rule as well as a unison of agreement from 14 exchanges, it may seem that the lobbying groups have reached a stalemate because, besides from TSXV, there has been no public declaration of support from Canada’s other exchanges. But, it is not quite an endgame yet.
Beyond Canada, ESG’s growing prominence and its relationship with short selling is not something that will be dying down anytime soon. It is believed that other beneficial owners are considering whether covered short-selling is fully aligned with ESG principles.
Globally, the war of words on short selling continues, further intensifying the spotlight on short sellers which, through the most optimistic lens, could help to further improve market practices.
Looking back to previous decades, regulation of short selling has heightened dramatically, and naked short selling is banned in almost all financial markets. It would not be out of the question then to expect a return of an alternative tick test rule in the next decade to benefit those small-cap issuers, including mining companies, technology companies and fintech issuers. Change may be slow, but it is coming.
The war of words was sparked in December 2019 by the world’s largest pension fund, the Government Pension Investment Fund (GPIF) in Japan, when it announced it was shutting down the foreign equity portion of its securities lending programme. It claimed that a lack of clarity around who the end borrower was and what they would use the asset for was at the root of its concerns.
In response, Elon Musk, the CEO of Tesla, an electric car maker and prolific short target, waded into the online debate around the ethics of short selling and called for the practice to be made illegal. Musk applauded GPIF’s decision by writing to his 29.9 million-strong online following: “Bravo, right thing to do! Short selling should be illegal.”
In terms of global regulators’ take on the practice, sentiment ranges from active encouragement to low-key hostility. That said, the past few years saw a series of Asian, Middle Eastern, Latin American and African market regulators actively developing their rulebooks to boost securities lending and short selling activity. For example, Argentina lifted its short selling ban in April 2018, and the Asia Securities Industry and Financial Markets Association proposed a workable securities lending regime in China in March last year that would also facilitate short selling.
Elsewhere, the European Securities and Markets Authority also published a report shortly after GPIF’s announcement to plant its flag squarely on the side of securities lending and short selling.
The EU watchdog concluded an investigation into “undue short-term pressures in securities markets,” which dismissed concerns from certain quarters of the financial market that securities lending and short selling were not compatible with environmental, social and governance (ESG) aims.
However, as has ever been the case with debates around short selling, for every argument won somewhere in the world, another is being lost.
A war on many fronts
While most interested parties’ attentions were fixed on the discontent in Asia, the debate around appropriate oversight of short sellers was also flaring back to life half a world away, in Canada.
A lobbying group named Save Canadian Mining (SCM) is currently fighting for Canadian stock exchanges to re-introduce a form of ‘tick test’, sometimes known as the ‘uptick rule’, for stock in the country’s junior markets.
A tick test requires short sales to be conducted at a higher price than the previous trade, with the idea being that you wouldn’t be able to overwhelm the market and put unreasonable downward pressure on stock prices.
Up until 2012, all Canadian exchanges featured a tick test for short selling, but it was removed following the publication of market research in the US that it was not an efficient method of stopping the type of short selling pile-on that it was created to mitigate against. The US also scrapped a similar rule based on the same findings, but subsequently brought it back in a modified form.
The argument being put forward by SCM is that although the removal of the tick test has helped Canadian markets evolve in a macro sense there is now a dynamic where short selling activities, high frequency trading, and algorithms are exploiting the lack of a tick test to the detriment of Canada’s junior markets.
However, for Canada to also reintroduce a form of tick test, Canada’s self-regulatory organisation for the investment industry, the Investment Industry Regulatory Organization of Canada (IIROC), has said that all 14 exchanges must agree on the benefits of doing so and present new evidence to back up the move.
“IIROC’s decision to repeal the tick test restrictions in 2012 was based on studies we had conducted which demonstrated that the tick test had no appreciable impact on price movement,” a spokesperson for the regulator explains. “Although we are not re-evaluating the tick test at this time, we would consider it in light of any new empirical evidence.”
So far, concrete new evidence has not been forthcoming, although anecdotal evidence has suggested that the unilateral removal of the rule has had a disproportionately negative effect on Canada’s junior markets, specifically in mining, technology and fintech sectors due to their limited stock liquidity. Hence the formation of SCM.
Nonetheless, SCM has gained the attention of Canada’s TSX Venture Exchange (TSXV), which has confirmed it is considering re-introducing a version of the tick test that would restrict traders to only shorting a stock if it was on an upward trajectory.
The proposed rule would apply to stocks of companies in the ‘junior markets’, meaning listed companies under CAD 250 million (US$191.22 million), and would give a floor and ceiling to short selling.
Brady Fletcher, managing director, head of TSXV at TMX Group explains that the exchange is also pushing for IIROC to refresh its failed trade study and take a more holistic look at market structures for these junior issuers.
Fletcher adds that conversations are being had around whether reinstating the tick test is appropriate or if it makes more sense for venture listed companies to only trade on one market.
In this vein, Fletcher explains that the increasing number of exchanges and alternative trading systems creates issues when it comes to updating or overhauling market rules.
“It does create a challenge for us because we cannot go and make changes or test things out that we think could potentially benefit smaller or more illiquid issuers,” he says. “We need to question whether having 14 trading venues makes sense when you’re a company that trades by appointment, or does that end up fragmenting liquidity. What we really need to do in Canada is see where we can change and where we can improve.”
Ace in the hole
Despite a slow start, those seeking to impose stricter rules on short sellers on Canadian exchanges do have a trump card: the fact that the US re-imposed a form of tick test a few years after it repealed it, coupled with the precedent that Canada and the US markets are inclined to lean towards continuity and following one another.
The tick test made its first debut in the US in 1938 and remained until 2007. Canada then followed suit in 2012 when it was removed by IIROC.
But, in 2010, the US Securities and Exchange Commission (SEC) approved rules that would require the country’s exchanges and the Financial Industry Regulatory Authority (FINRA) to pause trading in a stock if the price drops 10 percent or more in five minutes.
The rules, which were proposed by the national securities exchanges and FINRA and published for public comment, came in response to the infamous “flash crash” of 6 May 2010, according to the SEC.
The crash saw the prices of many US-based equity products experience rapid decline and recovery in a single day, demonstrating the impact of high-frequency traders.
Speaking in June 2010, then SEC chair Mary Schapiro, who convened a meeting of the exchange leaders and FINRA at the SEC following the market disruption, said: “The 6 May market disruption illustrated a sudden, but temporary, breakdown in the market’s price-setting function when a number of stocks and exchange-traded funds were executed at clearly irrational prices.”
“By establishing a set of circuit breakers that uniformly pauses trading in a given security across all venues, these new rules will ensure that all markets pause simultaneously and provide time for buyers and sellers to trade at rational prices,” Schapiro added.
Discussing the US’ alternative uptick rule, TSXV’s Fletcher notes: “During the financial crisis both Canada and the US banned short selling in certain financial institutions. Following that, the US put in the alternative uptick rule, which meant that if a stock was already under pressure – i.e they have seen a 10 percent share drop in one day – then it gives the long holders the ability to jump to the front of the selling queue.”
Fletcher adds: “Therefore, the title of calling it ‘the alternative uptick rule’ is really a bit of a misnomer because what it does is give long holders of stocks a preference to sell in their position before the shorters can continue to put negative pressure on a stock.”
Elsewhere, the US now also boasts a clear and prescriptive pre-locate rule, which means that anybody looking to go short in the US has to be able to prove where their borrow requirement was coming from. “Now, in Canada, we have something similar but it is a bit more of a commercially reasonable effort,” Fletcher explains. “The Canadian rule says that we have to have a ‘reasonable expectation’ of finding that borrow requirement at the time of completing the short sale.”
The IIROC spokesperson explains that its real-time market surveillance activities include monitoring for extreme price movement both up and down regardless of whether a short sale or otherwise.
According to IIROC, single-stock circuit breakers automatically halt trading for five minutes when a covered security’s price moves up or down beyond a specified threshold.
A game of groans
TSXV and groups like SCM have brought further debate to the table regarding short selling. And, as well as the tick test, SCM and TSXV have initiated a conversation on the market structure as a whole, which the exchange says needs to be looked at deeply to see what it should look like for entrepreneurs trying to access public venture capital.
However, considering IIROC requires new research favouring the reinstatement of the uptick rule as well as a unison of agreement from 14 exchanges, it may seem that the lobbying groups have reached a stalemate because, besides from TSXV, there has been no public declaration of support from Canada’s other exchanges. But, it is not quite an endgame yet.
Beyond Canada, ESG’s growing prominence and its relationship with short selling is not something that will be dying down anytime soon. It is believed that other beneficial owners are considering whether covered short-selling is fully aligned with ESG principles.
Globally, the war of words on short selling continues, further intensifying the spotlight on short sellers which, through the most optimistic lens, could help to further improve market practices.
Looking back to previous decades, regulation of short selling has heightened dramatically, and naked short selling is banned in almost all financial markets. It would not be out of the question then to expect a return of an alternative tick test rule in the next decade to benefit those small-cap issuers, including mining companies, technology companies and fintech issuers. Change may be slow, but it is coming.
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