The term Regulation SHO refers to legislation that updated and strengthened the laws concerning short sales of securities. Regulation SHO established trading standards intended to lower the opportunity for traders to engage in unethical naked short selling practices.
A trader will short a stock if they believe its price will fall or they are trying to hedge against price volatility. If the trader is correct, and the price of the security falls, they can buy the stock at the lower price and realize a profit from the transaction. When a trader shorts a stock, they are borrowing the stock from their broker. These securities can come from the firm's inventory, a margin account of another firm's client, or even a lender.
Regulation SHO became effective on January 3, 2005. This rule attempted to address concerns about failures to deliver securities and other potentially abusive forms of naked short selling. There are four general requirements outlined in Regulation SHO:
- Rule 200: requires orders placed with their broker to be marked as long, short, or short-exempt.
- Rule 201: requires trading centers to establish, maintain, and enforce policies and procedures reasonably designed to prevent the execution or display of a short sale when a circuit breaker rule has been triggered.
- Rule 203: requires brokers to have reasonable grounds to believe a security can be borrowed and delivered (locate rule) on its due date before effecting a short sale.
- Rule 204: requires brokers and dealers that are participants of a registered clearing agency to take action to close out failure to deliver positions, including purchasing or borrowing securities of like kind and quantity.