SmicroCaps

Part of the reason behind today's rally was due to Representative Barney Frank's statement that the uptick rule will be back in effect within a month.  I wrote about this briefly in this article about Steve Forbes' solution to the financial crisis and I still believe that naked shorting is by far the bigger issue.  Outside of the professional investing/trading circles, short selling is highly criticized, and I was reminded of this fact by the many comments on my first bearish article at SeekingAlpha.

Short selling is necessary to help markets operate efficiently, but it can be abused.  Prime brokerages and other security dealers whose compensation is based on transactions aren't going to turn away clients, even when shares are hard to come by.  Typically, broker-dealers have up to three days to deliver shares that have been sold short.  Retail brokers won't even lend their accounts shares unless they have possession of them.  Don't get me started on the opportunity that I lost when my brokerage couldn't lend me shares of Dendreon (DNDN) in April of 2007.  My complaints are nothing compared to those that the SEC has received for its ineffective policing of naked short sales.  The SEC can only do so much given its current order ticket requirements.  There's an old school solution that can help them track and enforce short selling practices.

I'm not suggesting that we bring back stock certificate.  Though OneShare.com is making a pretty good business doing just that.  I'm thinking about picking up a share of Citicorp with a memorable inscription to help remember the lessons of this financial crisis and to decorate my living room wall.  My solution focuses on the red numbers on the stock certificate.  The concept of a serial number and a share (or block of shares) of stock has been long lost and nearly erased in the digital age.  I think it's time that we bring it back and make it a mandatory piece of order ticket sales. The SEC can allocate digital serial number blocks to various holders and specify minimum block sizes at their discretion.  If an abusive short seller tries to push through a trade, even a short term trade, with a block that is sitting in a cash account, the SEC can finally track them with a system like this.

Maintaining a system like this, however, requires a new school solution.  Hard disk defragmentation is a perfect model.  As you use your computer, blocks on a disk, groups of which make up single files, get overwritten.  These blocks can become fragmented and blocks that make up a single file can become highly discontiguous, which results in higher access times.  In the same way that an operating system performs routine disk defragmentation, the SEC can reassign digital stock serial number on whatever basis it sees fit as periodic short sale lending and overall trading disrupt block assignments (likely that this would be monthly or quarterly). 

With a system like this in place, the SEC would finally have the forensics infrastructure in place to fight abusive naked short selling.  This could have a huge impact on highly shorted names.  However, heavily shorted names are not all the same.  The metrics that we use to determine the extent that a stock is short sold vary greatly.  Some are relative to volume/liquidity and some are not.

The above top ten screen lists small cap companies (less than $2B in market cap) companies with greater than 20% of their shares outstanding sold short.  Certainly, each of these companies has different operational situations that need to be examined on a case by case basis.   Because these names have relatively strong daily trading volume, it is likely that they would benefit more from a new naked short selling forensic program rather than the restoration of the uptick rule.  A thicker order book would provide more resistance to a short seller attempting to crush the bid and move the stock price downward.

In this screen, which considers companies with greater than 10% shares short, there is a strong inverse correlation between days to cover and daily volume.   Here, both the uptick rule and naked short selling forensics would likely be useful.  As investors, we must consider how regulation changes will effect our holdings and these heavily shorted names should be impacted more than most others.

Disclosure: The author does not hold any positions in any of the mentioned securities at the time of this writing.