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Debate Rages On as Short-Sale Rule Nears End

Short trading in 19 major U.S. financial stocks will revert to rules governing other shares Wednesday as a Securities and Exchange Commission experiment against abusive short selling expires.

Market data company S3 Matching Technologies says short sales in the affected companies dropped after the emergency rule took effect but there is little consensus on how the market will react come Wednesday.

"My guess is that while this curtailed naked short selling in the short run, I suspect people found clever and sophisticated ways to work around (it) through derivatives," said John Welborn, an economist with investment firm The Haverford Group who studies short selling.

But Dylan Wetherill, founder of ShortSqueeze.com, a Web site that tracks short interest, said the emergency rule maintained strength and balance in the affected stocks.

"If the SEC removes the rule, it will give the short sellers the edge in the market they are looking for," he said.

Since the SEC's emergency rule went into effect July 21, short sellers have been required to pre-borrow stock in mortgage finance giants Freddie Mac and Fannie Mae and 17 Wall Street firms such as Goldman Sachs before executing a short trade.

Investors who bet on falling stock prices also have been required to deliver the securities by the settlement date -- obligations that forced Wall Street to change the way they traded those stocks.

When SEC Chairman Christopher Cox announced the emergency rule July 15, he said the agency aimed to stop unlawful manipulation of stock prices that threatened the stability of financial institutions.

Cox has said he wants to broaden the rule to include more stocks, but it was unclear how quickly the SEC would act.

Now the markets are calmer and the SEC is not expected to propose a new rule by Tuesday.

"We will go back to the world as it was the day before Cox testified that the emergency order was coming," said Travis Larson, spokesman for the Securities Industry and Financial Markets Association, which represents broker dealers.

Al Greenberg, head options trader at broker-dealer BNY ConvergEX Group said "our strategies remained pretty much the same. What did change, however, was the level of compliance involved before making trades."

Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making a profit when the price drops. It is a legitimate form of trading that can prevent stocks from being overvalued, but often blamed when a company's shares fall.

The SEC's rule was aimed at cracking down on illegal naked short selling -- when an investor sells stock that has not yet been borrowed.

But the notion that the SEC was offering protection for a select group of companies upset various market players and prompted at least one lawmaker and the American Bankers Association to call on the agency to expand its list.

The hedge fund industry and short sellers also chided the SEC and said the rule would constrain normal market operations.

"Before we can make a trade that involves short stock in those affected names, we have to verify that the customer has pre-borrowed the stock and then get confirmation from the firm that lent the stock. This slows us down and eats up quite a bit of manpower that can be better used elsewhere," Greenberg said.

SIFMA's Larson agreed and said it was a painful process as Wall Street took a highly automated process and had to make it almost entirely manual for these 19 stocks.

Market makers were exempted from the pre-borrow requirement to ensure trading in the 19 stocks remained liquid.

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