US markets will soon move to faster settlement of trades. This change could seriously damage some short selling hedge funds.
From a new report in The Trade News:
The Securities Industry and Financial Markets Association (SIFMA), the Investment Company Institute (ICI), and The Depository Trust & Clearing Corporation (DTCC) are working together to reduce the T+2 settlement cycle in the United States to T+1 by the first half of 2024.
This could quickly lead to regulators requiring that trades settle same day, or T+0, according to a Deutsche Bank report. Faster settlement could have two disastrous effects on short sellers:
Naked Short Selling Gets Harder
Some hedge funds sell short shares without ever borrowing them first. This mostly illegal practice shows up in huge, persistent fails to deliver in volatile meme stocks like GameStop Corp. and AMC Entertainment Holdings Inc.
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If trades have to settle faster, it will be harder to sell short shares you don’t own while possibly locating some shares later. You have less time for your incomplete trade to sit in limbo.
Without this powerful tool to push down stock prices, it will be more difficult for short sellers to tank a stock.
Brokers Are Less Likely to Suspend Trades in Volatile Stocks
Last January, Robinhood Markets Inc. and other brokers stopped users from buying shares of volatile meme stocks like GameStop and AMC. Their rationale was that given how much the stocks’ prices were moving, they couldn’t afford to put up the necessary margin to process the trades.
After buy orders were stopped, GameStop stock plummeted:
Brokers like Robinhood have to post money with clearinghouses such as the National Securities Clearing Corporation (NSCC). The more volatile a stock and the longer it takes to settle the trade, the more money they have to cough up.
If the time it takes for a trade to settle is cut in half, the amount of margin brokers would have to post would likely be cut in half as well. Indeed, reducing margin requirements is one of the main reasons why regulators want to move to T+1 settlement.
Where This Leaves Short Sellers
Short sellers in recent years have had a lot of advantages.
Loose trade settlement rules made naked shorting easier. And if that failed, brokerages might bail you out by stopping retail traders from buying the stock to squeeze you!
And even with these advantages, hedge funds like Melvin Capital lost billions on their short positions. How big would the hole have been without these tailwinds?
There is one good piece of news for shorts: there may be a loophole. SIFMA, a Wall Street Lobby, is seeing to that:
…SIFMA requests an exemption from SEC Rule 15c6-1 for security-based swaps, which are generally bilateral and executory in nature.
This would make swaps exempt from the faster settlement rules. Hedge funds like Archegos have already used these derivative contracts to make massive bets out of the public eye.
If the move to T+1 settlement makes short selling harder, I expect more funds to move into swaps to avoid the rules. I encourage the SEC to find a way to make T+1 apply to swaps transactions as well.
The future is looking darker for short selling hedge funds. The question is, will regulators create a more efficient market for everyone, or let lobbyists pick apart their work piece by piece?
What do you think new settlement rules will mean for short sellers? Leave a comment at the bottom and let me know!
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Photo: Prominent short seller Gabriel Plotkin, founder of Melvin Capital
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