Extracted from Law360
It's not often that highly technical stock trading regulations work their way into popular discourse. But that's what has recently happened in ongoing social media hype regarding the significance of short interest in stocks, which refers to the total open short positions in a stock on a given date.
During the first half of this year, widely publicized surges in meme trading — which describes the phenomenon of social media-driven surges in specific stock trading, frequently with acknowledgement from buyers that their purchases are disconnected from any change in the economic performance of the issuer — have often been accompanied by social media posts that decry reportedly excessive levels of short interest in a given stock.
While the Financial Industry Regulatory Authority, the primary regulator of stockbrokerage firms, has explained[1] that a key problem in the widely hyped justifications of this movement is the misapprehension and limitations of the data being used to drive it, the organization has also announced[2] that it is considering changes that would seek to dramatically expand and alter current short interest reporting obligations.
Although FINRA's proposals are still conceptual in form, brokerage firms — in particular, the larger firms that clear transactions and hold customer securities — will stand to bear heavy operational impacts to a reporting process that is already burdened with technicalities and ambiguity.
Regulation of short-selling — in which persons who do not own a stock borrow and sell it, often (but not always) with a view to profit off its decline in price — is governed by a highly technical set of regulations that are administered by the U.S. Securities and Exchange Commission, primarily under Regulation SHO.
FINRA, which is itself subject to SEC oversight, oversees the collection and public dissemination of short interest data.
While popular conversations about short-selling often center on the morality of the tactic, the regulation of short sales does not reflect any principle-based judgments on whether a person should or shouldn't be allowed to sell short a given security.
Rather, Reg SHO's requirements[3] focus on four technical requirements:
- An order marking rule that requires broker-dealers to correctly identify the directional position of a trade;
- A locate requirement that requires broker-dealers to have a reasonable belief they can borrow the necessary shares before effecting a short sale;
- A price test that attempts to limit the pricing of short-selling in certain extreme market conditions; and
- Close-out rules that require clearing brokers to resolve, or close out, any failures to deliver shares, whether or not those failures result from long or short sales.
While FINRA does not technically administer or interpret Reg SHO — that responsibility belongs to the SEC's Division of Trading and Markets — FINRA is in charge of administering the rules that require brokerage firms to collect and report short interest data.
The collection of short interest data serves the combined purposes of aiding FINRA in its examination and surveillance functions and providing critical price discovery information to the investing public.
Currently, broker-dealers have to provide FINRA with semimonthly reports of their gross short interest — which, according to the organization, is "a snapshot of the total open short positions in a security existing on the books and records of brokerage firms on a given date" — in equity securities.
What makes a specific short position reportable hinges primarily upon how the order giving rise to a position is marked by the broker-dealer that received the order (usually referred to as an introducing broker in this context).
Problematically, the firms that are required to report short interest to FINRA (i.e., the firms that hold customer securities) are not always in a position of knowledge to understand the marking applied by the introducing broker and/or whether a given short position has in fact resulted from a short sale — which Reg SHO defines as "any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller."
For institutional broker-dealers with potentially hundreds of thousands of reportable short positions, the operational challenges posed by this disconnect, left unaddressed, may only be exacerbated further by the changes being discussed by FINRA.
The short interest reporting rule places a considerable burden on clearing brokers that, due to the volume of their business, have to employ automated systems to generate short interest reports, but cannot without considerable, if not practically impossible, efforts accurately determine whether a given short position is reportable under the rule, or whether it is subject to one of the rule's enumerated exceptions.[4]
Both the SEC and FINRA have, especially during extreme market conditions like those during the depths of the Great Recession, subjected brokerage firms to strict examination standards in their compliance with short-selling regulation, in particular the locate and order-marking requirements.
In addition, FINRA has brought a number of enforcement actions against brokerage firms that inaccurately calculate and report short interest.
Against this backdrop, it is unsurprising that one of FINRA's reactions to recent market volatility events would be to assess the data reporting regime that is being widely reported to justify these emotional waves of trading.
While FINRA has not explicitly linked its proposed changes to short interest reporting to the meme trading phenomenon, recent events call into question the timing of these changes and whether their ultimate effect will be to promote improvements in the accuracy, efficiency and timeliness of short interest data collection and dissemination.
For its part, FINRA says that in order to better understand the market participants behind short-selling activity and also to better inform the investing public, it is considering modifying these rules to require more frequent reporting and dissemination of the data, on a weekly or even daily basis, and to require information to include not just short stock positions but also derivatives that are economically equivalent to short equities positions (like put options).
The organization also says that it is considering requiring firms to break out firm proprietary and customer account positions, and to provide short-position data on an account-by-account level, rather than as currently aggregated across a brokerage firm.
Additionally, FINRA is revisiting how it approaches surveillance of compliance with the SEC's Reg SHO.
Currently, when FINRA is conducting exams to identify the parties responsible for failures to deliver under the Reg SHO close-out requirements, it must manually contact and ask member firms to help it identify and track down the brokerage firms responsible for the relevant failure.
This can be especially relevant to FINRA when it is seeking to investigate potential abuses by market participants who are transacting in excess of available shares.
For FINRA member firms, the proposed changes to short interest reporting would represent a significant challenge in the frequency and content of required short interest reports, posing new challenges to back-office and technological personnel to amend legacy systems or adopt altogether new frameworks for collecting and generating data.
Equally or more important, it will require firms to adapt their supervisory structures to review and vet the accuracy of these enhanced datasets, which will widen the enforcement risks against investigations by a regulator that has historically shown an eagerness to impose large monetary fines and remedial measures against firms that experience technological failures in transaction and position reporting.
Finally, the proposed changes appear to leave unresolved the legacy issues that the industry has explained impose difficult-to-manage conceptual and technical challenges in simply defining what should be included in short interest reports.
For the individual investor, while FINRA's changes would have the ostensible benefit of providing more frequent and detailed short interest data for given securities, they would still leave in place many of the fundamental ambiguities, which FINRA has itself acknowledged, that are posed by competing sources of information about short interest and short volume.
As FINRA explained in a past investor advisory,[5] in addition to the short interest data that it compiles from members, it also publishes daily short sale volume reports, which reflect off-exchange trading in listed and unlisted (i.e., over-the-counter) stocks.
Because FINRA's current proposals do not cover the separate daily volume reports, it will leave unresolved the investor confusion that FINRA has acknowledged results from separate published datasets related to short-selling, which are redistributed and recalculated according to a variety of methodologies used by third-party media providers.
As a result, whatever changes may arise from FINRA's current review of short interest reporting, the potential for social media-driven intrigue over all the short interest data will remain.
FINRA is accepting comments to its concept proposal until Aug. 4. This is a key time for industry members to review FINRA's contemplated rule changes, assess how the proposed acceleration and expansion of the reporting requirements will impact their current technological and operational systems, and consider providing comments to FINRA in order to better inform the organization's development of any formal rule change proposals before they are finalized.
[1] "Short Interest – What It Is, What It Is Not," April 12, 2021, https://www.finra.org/investors/insights/short-interest.
[2] Regulatory Notice 21-19, "FINRA Requests Comment on Short Interest Position Reporting Enhancements and Other Changes Related to Short Sale Reporting," August 4, 2021, https://www.finra.org/rules-guidance/notices/21-19.
[3] https://www.sec.gov/investor/pubs/regsho.htm.
[4] https://www.sifma.org/wp-content/uploads/2017/05/sifma-submits-comments-to-the-sec-on-amending-finra-short-interest-reporting-rule.pdf.
[5] Information Notice 5/10/19, "Understanding Short Sale Volume Data on FINRA's Website," May 10, 2019, https://www.finra.org/rules-guidance/notices/information-notice-051019.