Reg SHO
Regulation SHO is a set of rules established by the U.S. Securities and Exchange Commission (effective January 2005) that governs short selling in U.S. equity markets, establishing requirements for broker-dealers to locate securities available for borrowing before executing short sales (the 'locate' requirement), mandating close-out of persistent failures to deliver arising from short sales within specified timeframes, and providing a framework to limit 'naked' short selling — where securities are sold short without a reasonable expectation that they can be borrowed and delivered. Reg SHO replaced earlier short-selling rules and was subsequently amended by Rule 201 in 2010 to reinstate an alternative uptick rule during severe market declines.
Key takeaways
- The 'locate' requirement mandates that broker-dealers have reasonable grounds to believe the security can be borrowed before accepting a short sale order — this is satisfied by querying securities lending desks or prime brokers.
- The 'close-out' requirement (Rule 204) mandates that fails-to-deliver on short sales must be closed out by purchasing or borrowing securities within 3 settlement days (T+3 for equities) of the settlement date.
- The 'threshold securities list' identifies securities with persistent fails-to-deliver; broker-dealers cannot accept new short orders in threshold securities unless the existing fail is closed out.
- Rule 201 (the alternative uptick rule) restricts short sales in any security that declines 10% or more in a single day, permitting short sales only at prices above the national best bid for the remainder of that day and the following day.
- Market makers and bona fide hedging activities have limited exemptions from certain Reg SHO requirements, recognizing the legitimate role of liquidity provision and derivatives hedging.
Explanation
Regulation SHO emerged from a post-dot-com regulatory review that found widespread failures in short sale settlement and evidence of abusive naked short selling practices in small-cap and mid-cap securities. Prior to Reg SHO, the regulatory framework for short selling in the U.S. was primarily the uptick rule (Rule 10a-1), which prohibited short sales on a downtick, and general anti-fraud and anti-manipulation provisions. The uptick rule was repealed in 2007 after empirical studies found limited evidence of its effectiveness in preventing manipulative short selling.
The locate requirement is the foundational element of Reg SHO's anti-naked-short framework. Before executing a short sale, a broker-dealer must have reasonable grounds to believe the security can be borrowed and delivered on time. 'Easy-to-borrow' lists compiled by prime brokers and securities lending desks satisfy this requirement for securities with ample supply in the lending market. For 'hard-to-borrow' securities — those with limited float, high short interest, or special corporate situations — the broker must specifically locate a lender and confirm availability before executing. This requirement prevents the most egregious form of naked short selling while preserving normal market-making and legitimate short selling functions.
The close-out requirements address the chronic settlement failures that, prior to Reg SHO, could allow shares to be sold short repeatedly without ever being delivered. Under Rule 204, a broker-dealer that has a fail-to-deliver on a short sale must close out the position by purchasing or borrowing the shares no later than T+3 (three settlement days after the settlement date). Failure to close out triggers a 'pre-borrow' requirement — the broker-dealer must actually borrow shares before executing any new short sales in that security, eliminating the ability to continue shorting a security while fails persist.
The Rule 201 alternative uptick rule, added in 2010 following the 2008 financial crisis and SEC criticism that unlimited short selling had contributed to cascading price declines in financial stocks, imposes a circuit-breaker-like restriction. When a stock declines 10% or more from the prior closing price, a price test is triggered: subsequent short sales may only be executed at prices above the current national best bid, effectively requiring short sellers to be patient limit-order sellers rather than aggressive market-order takers. The intent is to prevent short selling from amplifying panic selling during severe market dislocations, though academic studies on the rule's effectiveness have produced mixed conclusions.
Example
A hedge fund manager decides to short-sell 100,000 shares of a small-cap pharmaceutical company (XYZ Pharma) following a failed FDA trial. The prime broker checks the easy-to-borrow list and finds XYZ Pharma is a hard-to-borrow security with only 50,000 shares available in the lending market. Under Reg SHO's locate requirement, the prime broker can only facilitate a short sale of 50,000 shares — the amount it has specifically located. The hedge fund borrows the 50,000 shares and sells short. Three weeks later, XYZ Pharma's stock price falls 15% in a single session following negative earnings. Rule 201 activates automatically: for the remainder of that day and the following trading day, new short sales in XYZ Pharma can only be placed at prices above the current national best bid, preventing the hedge fund from adding aggressively to its short during the decline.
Related terms
Broker Dealer Cap Easy To Borrow Equity Exchange Financial Crisis Float Hard To Borrow Hedge Fund Participation Rate Algorithm Prime Broker Pyramiding