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SEC Approves Rule That Could Expose Short-Sell Positions

June 22, 2021 by Victoria Turner
The U.S. Securities and Exchange Commission in Washington, D.C. (Photo by Dan McCue)

WASHINGTON – The U.S. Securities Exchange Commission granted the accelerated approval yesterday of a rule change proposed by the National Securities Clearing Corporation related to its calculation and collection of supplemental liquidity deposits.

The change would have both activities performed on a daily rather than monthly basis. This change could expose hedge funds and brokers’ short sell positions.  

As seen in January’s short-sale frenzy by retail investors, short selling happens when investors borrow what they see as overvalued stock and sell it at the market price with the intention of buying it back at a lower price when returning it to the broker-dealer. 

In January, a group of retail investors banded together on online trading apps like online brokerage firm RobinHood and did the same with stocks such as GameStop and AMC. 

Robinhood then restricted trading on certain stocks, claiming it was necessary to meet deposit requirements set by the Depository Trust and Clearing Corporation. 

The move landed Robinhood in the hot seat before Congress. Charles Schwab, Interactive Brokers Group and TD Ameritrade also imposed some trade restrictions. 

However, Monday’s approval of the DTCC’s subsidiary’s proposal to “enhance its management of financial risks” associated with the calculation and collection of supplemental liquidity deposits might change the short sale game for hedge funds. 

It would essentially have them disclose their short positions, at least for the NSCC’s SLD providers, which will continue to be its 30 largest members or group of affiliated members. 

The NSCC is administered by the SEC and serves as a “central counterparty” to ensure financial transactions abide by their contracts and SEC requirements. As a clearance and settlement provider, it helps brokers mitigate the risk of their buy and sell positions, decreasing their number of payment obligations. 

However, as it stands, the supplemental clearing fund liquidity deposits that allow the NSCC to cover these risks were only calculated and collected before the equity options’ monthly expiration and if needed. 

The amendment will make these calculations happen daily, as well as create an SLD obligation that would allow for same-day calculation and collection of additional SLD if needed — enhancing the SLD disclosures. 

What happened in January was that a group of subredditors from the online platform Reddit caught wind of hedge funds’ short positions and essentially performed a “short squeeze,” where they bought declining stock and increased it exponentially, and some would say artificially. 

Essentially, these new retail investors played the same game as the hedge funds. This exposed the risky business behind short selling and prompted several hearings into insecurity within the securities trading landscape.

What exactly does this amendment mean for the hedge funds or other large affiliated members who engage in short selling? The seller of this stock does not own it, instead borrows it from the broker-dealer but must buy it back in the future. 

When they see the stock is overvalued and expect it to decline, they buy it back at a lower price and pocket the difference. Brokers can essentially do this in bulk. 

If the price rises; however, the investor has to pay that difference and take a loss. Much like a casino needs to have the money in its vaults for the chips it hands out, the NSCC wants to make sure it has enough supplemental deposits it can collect in its clearing fund to cover if a member defaults.

In its ruling, the SEC found the amendment “should help NSCC ensure it can complete settlement for all its members in the event one member defaults, which the Commission believes should promote the prompt and accurate clearance and settlement of securities transactions.” 

It remains uncertain if anything else will change in the regulatory landscape, but the matter is far from over with Robinhood and large brokerages. Charles Schwab, TD Ameritrade and Interactive Brokerage Group are still amid lawsuits for the alleged trading restrictions. 

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