1. Short Selling vS. “naked” Short
Selling
Mark-to-Market vS. Uptick rUle
hajiMUrad gUlahMadov
the city UniverSity of new york/
Brooklyn college
[r. SiSti]
[BUS. 80.2]
1

2. [2009-03-14]
taBle of content:
1. Abstract………………………………………………………3
2. Hedge Fund……….…………………………………………4
2.1. What is Hedge Fund………………………………....4
2.2. Hedging methods- Short-Selling…………………..6
3. Naked shorting……………………………………………...7
3.1 Will “Temporary Ban” on Short Selling Solve the
Problem?”…………………………………………8
4. The Uptick Rule vs. Mark-to Market……………………..9
4.1Mark-to Market Rule……………………………..10
4.2The Uptick Rule……………………………….10
5. Conclusion………………………………………….11
6. Bibliography…….…………………………...……….12
2

3. Introduction
In this paper I will analyze the concept of Hedge Fund, how hedge funds are
operated, hedge fund issues, market manipulation and speculation, short-selling strategy,
naked short selling, IOUs, what the reason was for major banks such as Bear Stearns,
Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Morgan Stanley and Goldman Sachs,
as well as Europe's Halifax Bank of Scotland and Fortis NV to have financial trouble,
The U.S. Securities and Exchange Commission’s temporary ban on short selling,
concerns about mark-to-market accounting rule and advantages of uptick rule. During my
research, I have used different government sources (documents) as well as private owned
web sites and reliable finance related articles from various sources and academic papers.
This article offers critical analysis of the subject. The main goal of this paper is to explain
short selling, and the importance of this method for “Hedge Fund” and to analyze the
difference between naked short selling and lawful short selling. It also provides a
perspective on the current issue “naked” short-selling and “uptick” rule that have been
ignored by hedge fund regulators for long time period. Another aspect of this paper is to
examine “Mark-to-Market” accounting rule and “Uptick” rule and to determine which
rule is more efficient during current financial crisis based on my research and academic
knowledge of Hedge Fund.
3

4. Hedge Fund
What is Hedge Fund?
First, I will analyze the concept of Hedge Fund. As there is no specific
description, it is explained that hedge funds are basically funds operated by an investment
company, which use very different strategies to gain the highest possible profit on their
investments. They invest in all kinds of very sophisticated financial assets, and then sell
parts of this portfolio to investors by issuing shares. If we analyze it practically we see
that hedge funds are only accessible for wealthy individuals and institutional investors,
unlike mutual funds which are accessible to regular households as well as other investors.
Financial sliding of hedge finds can put major banks and private investors at a
huge risk that can have a negative impact on country’s overall economy. When there is
depreciation on currency the hedge fund manager usually sells their assets of that
currency. Often, other market participants follow funds with high reputations, and this
further drives down the currency's price. In this case, Central banks may not be able to
neutralize these changes. Because hedge funds have great power and influence on other
market actors, which implies that hedge funds even can break currencies. For example,
hedge fund manager George Soros’s attack on the English pound in 1992.1
G.Soros’s
speculation on a depreciation of the currency resulted in British currency to be out of
European fixed exchange rate. There are many other examples as well in hedge fund’s
history. For instance, the speculative attack on the Thai Baht and other South Asian
currencies 1997, which caused to a remarkable Asian crisis.2
1
http://www.twnside.org.sg/title/pok-cn.htm
2
http://www.imf.org/external/pubs/ft/issues/issues19/
4

5. Even though there is no accurate data available, there are various data providers
estimated that how large the hedge fund industry really is in terms of assets under
management. Chart 1 shows estimate by Hedge Fund Research (HFR) data provider for
previous years. In this data it shows that assets under management of the overall hedge
fund industry grew by $403.9 billion to $1.875 trillion from 2006 to Q1 2008.3
Chart 1: Assets under management in global hedge fund industry
Source: Alternative Investment Solutions, Hedge Fund Research, Hedge Fund
Intelligence, Hedgefund.net
Hedge Fund is being fast growing financial industry and gained great potential
over time because of less regulation and transparency is applied. Nowadays hedge funds
are receiving attacks from media and there is a negative public opinion among the
population because of existing Hedge Fund concerns. There are several critical issues
3
http://www.scribd.com/doc/13255273/AIMAs-Roadmap-to-Hedge-Funds
5

6. being discussed by various experts, politicians, economists etc. on the subject of fraud at
hedge funds, its risky strategies, less regulation by the government (tax exemption) and
non sustainability indicators etc. But today’s the hottest topic is market manipulation
which means when investors use different methods to make a profit by betting either on
changes in the prices of securities or primary assets. One of the methods of speculation
and market manipulation is found in short-selling strategy which considered as a cause of
major financial institutions to collapse. During recent years some hedge funds have been
found guilty because market manipulation is an illegal activity under the Securities
Exchange Act of 1934, and in Australia under Section s 1041A of the Corporations Act
2001.4
Principally, market manipulation means that hedge funds will try to influence
prices by spreading misleading information that will probably affect other investors'
demand for a security. These kind of changes related to price can be very profitable for
funds.5
Short-Selling
As it has been defined, short-selling is a transaction in which investors borrow
stocks and sell them by assuming that prices will fall and they would be able to buy the
borrowed shares at a lower price to repay the original loan. Investors either can gain
profit or lose by just predicting. Under harsh “bear” market conditions, short sales are not
favored because it is considered that it caused declining market movements.
Consequently, some experts and politicians pushing market regulators to put some strict
rules on short selling.6
4
http://www.sec.gov/about/laws/sea34.pdf
5
http://www.afajof.org/pdfs/2004program/UPDF/P306_Asset_Pricing.pdf
6
http://www.investopedia.com/university/shortselling/shortselling1.asp
6

7. Because of recent concerns about short-selling, market regulators took some
emergency actions and amendments. But concerns should not be about short-selling, as
short-selling is a critical and legal market activity. Instead, the actual concern has to be
on stock manipulations such as naked short-selling that hide themselves within valid
activities such as sale shorting. But how do market regulators let investors to use naked
short-selling method?! The answer is obvious. It is because of loopholes that exist in the
U.S. stock settlement system. Because of these loopholes, when traders sell shares but
fail to deliver, it creates serious problems and this is called “IOUs”7
. There is a big
difference between market manipulation and short-selling. Short-selling cannot force
down your share price unless buyers do not want to preserve your share price. For
instance, let’s consider if XXX Company’s share wanted to be sold for higher price than
$1 by it’s investors but nobody buys those shares at that price. It means XXX Company
will trade its shares at $1 or lower price. In this case, it does not make any difference if
you have short-sellers or not. From this case we can conclude that the reason for stock
prices to fall is indeed people who will buy stocks at the higher price which is depend on
company’s competence capability.
Naked Short-Selling
In contrast to short-selling, as stated above, naked short-selling is illegal action of
selling shares. Because traders sell stocks that they do not even own. As I mentioned
before, due to many loopholes in the rules and different trading systems, naked shorting
still exists even though The Securities and Exchange Commission (SEC) denies this fact.
On the other hand, The SEC announced that, there were $14.9 billion in stock IOUs
7
http://www.investopedia.com/terms/i/iou.asp
7

8. during the second quarter of 2008. But public data shows more than that, and as Patrick
Byrne stated in his article, “Naked in Wonderland” that this pail may be over $150 billion
or more.8
It is said that naked short selling played a role in the troubles of Bear Stearns,
Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Morgan Stanley and Goldman Sachs,
as well as Europe's Halifax Bank of Scotland and Fortis NV. After all these major
downturns, The SEC decides to take an action even though it was too late to save many
of these major companies. It was reported on The SEC’s press release that on September
17, 2008 The U.S. Securities and Exchange Commission put a temporary ban on short-
selling of all financial companies’ securities in order to fight against “naked” short-
selling of securities and help to stabilize trading in the 799 financial companies.9
Interestingly, the SEC has not realized these illegal activities during all of these years and
it has not become an issue until major companies starting Bear Stearns, then continuing
with The Washington Mutual, Bank of America, Fannie Mae, MBIA, Ambac, and close
to 50 smaller financial firms have appeared on the SEC “threshold” list and their stocks
have “failed to deliver” and a lot of people lost their jobs. There is one common reason
for all these companies to be on The SEC’s threshold list and the reason is “naked” short
sellers attack. Because if we realize a media support, and a blast of hedge fund phantom
stock, then pause over and over, it will eventually decrease the stock’s price to very low
price which was the main reason of companies to fail.
Now, there is a contradiction, after The SEC commission adopted “T+3”, Rule 203(b) (3)
in Regulation SHO, Rule 10b-21:
Will “Temporary Ban” or these changes on Short Selling Solve the Problem?
8
http://www.forbes.com/2008/09/23/naked-shorting-trades-oped-cx_pb_0923byrne.html
9
http://www.sec.gov/news/press/2008/2008-204.htm
8

9. - As I discussed before, short selling is not the heart of the problem but it is indicative
of it. Banning short selling for some period will not do so much to change the fact that
the global banking system became illiquid as it shows in Chart 2. The equities of the
world are enormously decreasing. This SEC act will not prevent companies and major
banks from bankruptcy because banks are short of funding.
Chart 2: Equities: U.S. and World
Source: Barclays Wealth
Uptick Rule vs. Mark to Market
There are many arguments made against “Mark to Market” accounting rule and it
has been observed that this rule is not efficient in security transactions and overall during
financial turmoil. In this section, I will analyze two types of rules that apply to security
transactions. And I will conclude which rule is more accurate and best to use.
9

10. “Mark to Market” is an accounting rule that requires banks to write down the
value of a securities or portfolios based on the market values but not book value.10
And
today many banks across the country are required or forced by the SEC to write down the
value of all securities which essentially raises a capital to cover all the losses. In the
economic situation like today to take losses rather than to write down actual value of
securities puts more stress on banks which is not a smart movement. If there are many
disadvantages of this system why still use it?!
In contrast “Uptick” rule requires that every security transaction be entered at a
price that is no less than the price of the previous transactions. The uptick rule’s
advantage is that in short selling method it avoids traders to sell assets or securities in a
lower price when an asset or security is already experiencing declining prices.11
In
addition, this rule will avoid to some extending naked short-selling which is beneficial to
banks.
There have been many discussions either to restore uptick rule or leave mark-to-
market accounting rule, but still there is no final decision made, yet. One of the critics,
Steve Forbes who was a Republican candidate in the U.S. Presidential primaries and the
editor-in-chief of business magazine Forbes also wants The SEC to restore uptick rule as
he discussed it in his article “How Steve Forbes Would Fix the Economy”.12
In addition,
fund managers such as Ronald Muhlenkamp and Marty Whitman also support Forbes
argument. But oppositely, in 2007 the SEC rescinded the uptick rule which caused
today’s major companies’ failing. Recently, U.S. Treasury Secretary Timothy Geithner
reported on The Wall Street journal that attempts to rescind mark-to-market accounting
10
http://www.investopedia.com/terms/m/marktomarket.asp
11
http://www.investopedia.com/terms/u/uptickrule.asp
12
http://www.forbes.com/2009/01/30/fannie-freddie-mortgages-davos-intelligent-
investing_0202_davos.html
10

11. rules would cause to an attrition of evaluation of risks at banks.13
But there is still hope
that uptick rule will be restored as in March of 2009, the SEC Chair Mary Schapiro, Rep.
Barney Frank of the House Financial Services Committee are still considering this
alternative.
Conclusion
After analyzing different aspects of Hedge Fund such as short-selling, naked short
selling, mark-to-market and uptick rules, by using different sources, I can conclude that
in current financial circumstance where the stability of the market is under threat, the
SEC must take more serious actions against regulation on naked short-selling by not
putting ban on short selling because legitimate short selling is a vital and very important
financial tool in global financial markets. There is no need to isolate hedge funds and
discriminate against particular class of investors by making any changes to laws or
regulations because banks are short of funding and instead the SEC has to restore the
uptick rule which is more efficient and by using this rule it will have more control over
illegal naked short-selling.
Bibliography:
13
http://online.wsj.com/article/SB123687550364409037.html#mod=testMod
11

12. 1. Chandra Hardy, Third World Economics No.176, 1-15 January 1998,
“High-stake poker game moving on to G-7?”
http://www.twnside.org.sg/title/pok-cn.htm
2. Barry Eichengreen, Donald Mathieson, 1999 International Monetary Fund
ISBN 1-55775-849-2 September 1999, “Hedge Funds: What Do We
Really Know?” http://www.imf.org/external/pubs/ft/issues/issues19/
3. Alexander Ineighen, Kurt Silberstein, November 2008 “AIMA’s Road Map To
Hedge Fund” http://www.scribd.com/doc/13255273/AIMAs-Roadmap-to-Hedge-
Funds
4. SECURITIES EXCHANGE ACT OF 1934, downloaded from Committee Print
108-B of the Committee on Financial Services of the U.S. House of
Representatives, and was prepared at the direction of that Committee
http://www.sec.gov/about/laws/sea34.pdf
5. Rajesh K. Aggarwal and Guojun Wu March 11, 2003 “Stock Market
Manipulation — Theory and Evidence”,
http://www.afajof.org/pdfs/2004program/UPDF/P306_Asset_Pricing.pdf
6. Brigitte Yuille, “Short Selling: What Is Short Selling?”
http://www.investopedia.com/
7. Investopedia dictionary, “IOU”
8. Patrick Byrne 09.23.08, “Naked In Wonderland”, Forbes,
http://www.forbes.com/2008/09/23/naked-shorting-trades-oped-
cx_pb_0923byrne.html
9. The Securities and Exchange Comitee, Washington, D.C., Sept. 17, 2008, “SEC
Issues New Rules to Protect Investors Against Naked Short Selling Abuses”
http://www.sec.gov/news/press/2008/2008-204.htm
10.“Mark To Market – MTM”,
http://www.investopedia.com/terms/m/marktomarket.asp
11.“Uptick Rule” http://www.investopedia.com/terms/u/uptickrule.asp
12.Steve Forbes, 02.02.09 “How Steve Forbes Would Fix The Economy”
http://www.forbes.com/2009/01/30/fannie-freddie-mortgages-davos-
intelligent-investing_0202_davos.html
13. KARA SCANNELL, March 13,2009 “Regulators Draw Fire in Congress” , Wall
st. http://online.wsj.com/article/SB123687550364409037.html#mod=testMod
12