The short-selling rule and unintended consequences

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When you start monkeying around with markets, strange things happen. This is what the SEC is about to learn as market makers from the seven options exchanges are preparing to ask for exemptions from the new anti-free market SEC short-selling rules. See the article below (emphasis in article).

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Tennille Tracy of Dow Jones Newswires reports:

The seven U.S. options exchanges are preparing to ask for an exemption from a new Securities and Exchange Commission rule aimed at slowing short-selling of stock in financial companies, people familiar with the effort said Wednesday.

By putting the kibosh on so-called naked short-selling in companies like Fannie Mae, Freddie Mac and Lehman Brothers, the SEC has complicated life for the market-makers in the options market.

Options market-makers routinely engage in short-selling to hedge positions they take with clients. The SEC’s July 15 decision disrupts that commonly used trading strategy and makes it more expensive to conduct business as usual.

My book makes a market in nearly every name on [the SEC] list,” said Andy Schwarz, founder of AGS Specialist Partners. “This affects our book in a big way.”

Short sellers are betting that the price of a stock will fall. They do so by selling borrowed stock and then repaying the stock later, hopefully at a lower price. Some investors making such bets hoping to profit when a stock gets cheaper. Others, like options market makers, may merely be trying to offset the risk they take on when selling customers options that rise in value when stock prices fall.

WSJ, 16 Jul 2008

The short-selling rule smacks of obvious panic. It is a regulatory anti-free market solution slapped on in a hurry. Obviously, the Feds want to prop up Fannie, Freddie and other weak financial institutions by any means necessary.

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This rule will almost certainly stop naked short-selling. But, it’s the unintended and unforeseen consequences about which one has to worry.

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