By OTC Markets Group
More than 15 years since the Securities and Exchange Commission’s (SEC) adoption of Regulation SHO, short selling activity remains a misunderstood and a highly debated topic. Short selling can improve public markets—enhancing both price efficiency and liquidity—but it can also be abused.
Recently, with meme stock volatility and “short squeeze” debates raging through Reddit, the conversation is increasingly focused on this feature of Wall Street’s plumbing. Now is the time to bring facts into the conversation.
FINRA’s recent Investor Insights post outlines what short sale data is useful and what isn’t. FINRA Short Sale Daily Volumes [1] data, for example, can create a false impression of overall short selling activity in individual securities. As FINRA notes, “some market participants mistakenly conclude that the bimonthly short interest data is understated because the Short Sale Daily Volume File reflects volume that is much larger than the positions reported as short interest. However, short interest position data does not—and is not intended to—equate to the daily short sale volume data posted on FINRA’s website.”
First, Short Sale Daily Volume File only includes trades that are published to the public (Public media trade reports [2]), not the offsetting trades that are reported to FINRA for regulatory oversight and/or clearing (Regulatory non-media trade reports [3]).
Second, there are two types of market activity in short sales: directional investor orders and temporal market making. Directional orders represent investors selling borrowed shares in the hope of buying them back at cheaper price. Temporal short sales take place when a regulated broker-dealer engages in market making activity as a dealer by providing liquidity in the form of bids and offers that allow other investors to immediately buy or sell. In order to provide this critical market function, when an investor trades with a market maker’s offer to sell shares, the market maker will fill the order. As both a ready buyer and a ready seller of shares, the market maker will be purchasing and selling shares as buyers and sellers come into the market.
The market maker continues to provide bids and offers throughout the day and its position fluctuates between long and short – and often goes back and forth many times in a single day – as investors interact with its quotes. Whenever the market maker does not have a long position in the stock, its sales will be reported as short sales even though the market maker’s net position will likely continue to oscillate for the rest of the day based on investor demand. This essential market practice, also called bona fide market making, allows for continuous two-way quotations, improves liquidity and facilitates immediate efficient trade executions for investors through all types of market conditions.
If a market maker is representing an investor’s long sell order in their displayed quote (otherwise known as Limit Order Display), the public media report trade will show up as a short sale, and the long sale will be a regulatory non-media report. In the above situations, trades initiated by a natural buyer or a long seller, the media trade reports will be marked as short sales. This further creates confusion about short activity in the market.
In some cases, a market maker receives customer sell orders and is unable to or decides not to principally fill the customer order. The market maker effectively becomes an order router seeking to obtain the best liquidity for its customer. As the market maker interacts with bids in the market to fill the order, the trades are automatically allocated to outstanding customer sell orders that are executable at those prices. FINRA Rule 5320, known as the Manning obligation, requires that market makers immediately fill all live marketable customer orders at the same or better price, before allocating trades to a market maker’s own account. Depending on the market maker’s position in that moment, sell orders may be reported as “media” short sales to the public when the regulatory non-media trade report is a regular long sale.
As the above examples demonstrate, FINRA Short Sale Daily Volume File conflates directional investors (who have a true intent to sell short) with market maker short selling activity (who incur temporary short positions in order to provide liquidity to buyers) into one confusing number. This method of publication causes the aggregate volume to appear to reflect a higher concentration of directional short sale activity than is occurring. Professionals understand that separating actual customer short sales and calculating a separate net change in market maker positions at the end of the trading day would provide a better metric for investors and regulators in determining actual short sale activity in a trading day. Unfortunately, this important information cannot be ascertained from the current FINRA Short Sale Daily Volume File.
As a result, a stock that has little directional short selling and healthy bona fide market maker buying and selling will potentially show large Daily Short Volumes. Well intended folks may point to the Short Sale Daily Volume File data without understanding how trades are processed by market makers and reported and may end up misleading investors as to the actual magnitude of genuine short selling and where it is coming from.
Understanding short sale data and getting the facts straight helps support investor protection and will build investor confidence in our markets. We will be publishing a series follow-up pieces on what information sources market professionals use to understand short sale activity and ways to enhance the datasets available to investors. At OTC Markets Group we will continue to educate and improve access to information to ensure America’s capital markets remain the envy of the world.
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[1] While the FINRA Short Sale Daily Volumes data is collected and published by FINRA, it is under the direction of the SEC.
[2] “Public Media” reports shall mean reports of transactions submitted for public dissemination.
[3] “Regulatory Non-Media” reports shall mean reports of transactions not submitted for public dissemination.
