Setting up for a stock market crash

So an interesting thing is happening in the stock market, and I thought I'd blog about it cause it was interesting to me. If stock market stuff bores you, you might want to skip this post.

So, recently (a week ago or so), the SEC made a new temporary rule that investors will not be allowed to naked short the stocks of select, large, financial institutions. Basically, this means in order to sell shorts on those stocks, the brokerage selling the short must own the stock shares. Since there's was not really an issue with defaulting on naked shorts, and it's very market specific, the rule is not designed to prevent any negative effects, but rather strictly to manipulate the market.

Now, normally, a stock is pushed in both directions by stock buying and shorting. Buying pushes a stock higher, as more bids are fulfilled. Shorting pushes a stock lower, as it's basically the opposite pressure on the stock price (the brokerage is selling shares it holds for someone else onto the market, which pushes the price down).

Now something interesting happened as a result of the SEC rule: brokerages have marked the affected stocks as short-restricted, which means they're not selling shorts on them. Presumably, this was done to minimize risk of violating the SEC rule. It has the effect of pushing up prices artificially, because the normally present opposite pressure is suddenly removed.

All good? Well, not really. See, when the price would get pushed down by shorts normally, now it will widen the bid/ask spread until you have a transaction, at which point the price will plummet. It basically removes the force which smooths out the down trends in stock prices, and makes them fall off cliffs instead.

Now ask yourself, if you get bad news in the industry, and suddenly most of the stocks take a large, immediate nose-dive, what's going to happen? Well, you trip more limit orders all at once, which causes a mass sell-off. Suddenly, instead of a normal orderly price reduction, you have a panic-induced market crash. Way to go SEC, if your job is to manipulate the market to create a crash... not so good if that's not your job.

Anyway, it's interesting that such a small change could potentially have such a profound effect. In this case, a "small" market manipulation by the SEC could very well cause the next massive stock market crash.