SEC Curtailing Wall Street's Fifth Amendment

(MoneyWatch)  If you want to pick a fight on Wall Street, go into Harry's on Hanover Square sometime on a Thursday evening and loudly announce that you think restrictions should be placed on short-selling. Even if you don't get the short end of a zealous trader, you're unlikely to make friends fast.

Several months after temporarily banning short-selling in financial stocks, that's basically what the SEC is up to once again -- this time on a more permanent basis. Among the five new rules that the SEC is proposing is the occasionally-introduced "uptick rule," which requires short sellers to wait to sell shares until a stock trades at least a penny above its previous trading price.

Hedge funds and speculators are outraged. "Proposals to inhibit short selling have the effect of limiting this vital market-based antidote to corporate fraud and speculative bubbles, and must be carefully weighed," James Chanos, one of Wall Street's highest profile short sellers, said in a scathing statement on the SEC Tuesday. Chanos called the revision of short selling rules "ill-conceived."

There are few topics more emotive on Wall Street than the ability to place bets on a company's potential misfortune or mismanagement. Indeed, last year hedge fund manager and Wall Street blogger Eddie Elfenbein labeled the practice "the free speech of Wall Street," much to the agreement of other traders.

The analogy is apt, and the SEC is foolish to use recent market turmoil as an excuse to implement more restrictions on ways in which institutions can make money. In many cases, short selling serves as a highly protective function to investors, too. By enabling speculative investment vehicles such as hedge funds to limit the amount of risk they employ in a trade, freer short-selling rules arguably contribute to less market volatility.

In frontier markets such as Vietnam or Colombia, where short selling is not allowed, price swings are much wilder than they usually are in countries where the practice is allowed.

This is particularly the case with respect to the reintroduction of the "uptick rule." Market commentator Joshua Brown points out in a recent article that "if you don't restrict the buying of a stock that is up 10 percent or more, then imposing price restrictions on shorting would be hypocritical and would probably create more distortions of price and what one skeptic has called synthetic short activity."

That's a compelling argument. For example, take the late 1990s, when Internet stocks frequently rose far more than they declined in value. If stocks surge in that way again, imposing an uptick rule on share trading merely prolongs the rise in valuations to unsustainable levels.

At the very worst, it means that fraudulent companies such as Enron which use their share prices as a form of collateral for illegal Ponzi-style activities can exist for far longer -- and hence cause far greater damage -- than they otherwise would given more freedom in short-selling rules.

Short-selling wasn't the reason we got into the mess that brought the "house of cards" down last year, and it makes no sense to treat it as such.