Regulators have responded to Reddit short-selling pressure with new rules for market makers

Spark Global Limited Reports:

On June 23, a new rule was announced that could end the short squeeze frenzy we saw in 2021.

The rule essentially allows the NSCC to inspect more frequently whether a broker-dealer is meeting capital requirements. NSCC is one of DTCC’s clearing firms.

To understand why this rule change is so important and how it could affect short-squeezed stocks like AMC Entertainment (AMC) and GameStop (GME), let’s explain it in plain English.

New rule decomposition
Suppose your broker tells you that you need to have at least $1,000 in your account to keep your trading account in good standing. They check on the first of every month, and as long as you have money in your account on the first day, you’re fine.

So you can imagine that you might break below that level a few times throughout the month as you experience trading losses, but as long as you have at least $1,000 left on the first day of the month, you’ll be fine.

Now imagine that your broker checks your account balance every day.

You have to change your practices, because it’s almost impossible to get below $1,000 now because your broker checks it all the time. So you can choose to trade with less capital, or put more money into your trading account.

Either way, you can see how the rule change will affect your own behavior, so you can understand how this will affect broker-dealer capital requirements.

As a result, many traders involved in shorting GameStop (GME) and AMC Entertainment (AMC) believe these rule changes will significantly affect the ability of market makers and hedge funds to short stocks, which they believe will put downward pressure on stock prices.

Remember, there is no guarantee that these theories are right or wrong. These rules have been in effect for two weeks and we haven’t seen anything crazy happen, so the whole situation is still up in the air.

Why do capital requirements matter?

Read on and we’ll learn this once we explain some of the details of the rules.

What are the rules: New rules for market makers change capital requirements
The new rule published by the NSCC, called SR-NSCC-2021-002, updates the calculation of a measure called supplementary liquid deposits (SLD). The SLD is one of many benchmarks NSCC uses to ensure that its members are liquid and able to meet trade settlement.

It is essentially a formula for identifying high-risk members who need to make additional deposits to NSCC.

Prior to this rule change, the SLD was calculated monthly before and after the expiration of the option.

Recall from the example above that your broker checks your account balance once a month. NSCC now calculates the SLD for each business day, even on the applicable day.

This reduces broker-dealers’ “wiggle room” with respect to NSCC capital requirements, since they are scrutinised more frequently.

In addition, it uses these more frequent snapshots to observe member behavior more closely to better calculate SLD, rather than purely using historical data.

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