April 30, 2007
Members of the Commission,
Does the Securities and Exchange Commission have a standing policy of zero tolerance to abuse or fraud or is some limited levels of abuse acceptable behavior?
I ask this specific question after reading the most recent comment memo submitted by the American Stock Exchange, Boston Options Exchange, Chicago Board Options Exchange, International Securities Exchange, NYSE/Arca, The Options Clearing Corporation, and Philadelphia Stock Exchange. These exchanges apparently want zero tolerance to be lifted and has asked the Commission to accept a certain threshold of potential abuses.
According to the analysis provided by the NASD and used as rationalization in the comment memo referenced, the exchanges are seeking no further reforms to the exemptions presently in place for members of the industry because the level of companies with persistent failures associated with such exemptions are 3% if you consider the options market exemptions and less than 20% if you consider all market making exemptions. The exchanges theorizing that this level of possible abuse is miniscule relative to the overall size of the markets as a whole.
The exchanges thus explain that limiting the exemptions would create liquidity problems and thus wider spreads on the equity or options markets. The exchanges are engaged in a smoke and mirrors campaign.
Consider it instead this way.
If less than 3% of all SHO companies have persistent settlement failures associated with options exemptions, than the implication is that for 97% of all SHO companies the options market maker is not using the exemption to any major degree. Since only 4% of publicly traded companies are theoretically on the SHO list at any given time, we are really talking about 3% of 4% or .12% of all publicly traded companies require an options market maker to oversell the market to extreme and persistent levels of settlement failure.
In a zero tolerance market, would it not be more prudent to protect these .12% public companies by restricting the liquidity offered in the marketplace instead of run the risk that market abuses that could impact these companies and their investors takes place?
Likewise, the exchanges calculate for their memo that less than 20% of the SHO listed companies on the NASDAQ are there due to market making exemptions is the cause for the persistent and excessive fails. I again run the calculations and 20% of 4% is 0.8% of all public companies are on the list for excessive and persistent failures due to market making activities of extreme selling nature. What is the risk vs. reward of unlimited market making exemptions when the exemptions are infrequently used to create such excess liquidity that the result is persistent and excessive failures?
The members have continually used the threat of reduced liquidity should the exemptions provided them be limited. Not once has the members discussed the potential impact the added liquidity has to the actual business operations whose securities have traded to the excessive failures created by the exemptions. It is not their concern as the market price of these public companies is not where revenues are created – liquidity is.
The only time a member is impacted by the cost liability of the market in a company is when the member is forced to cover above the prices sold. Present exemptions have allowed members to control a market to minimize this liability despite what such actions may mean to the true pricing in the marketplace.
There must be a point of equilibrium so that every investment vehicle investor, member, etc takes on an assumed level of risk with an equal opportunity to potential profits.
What makes this memo by the exchanges even more concerning is the fact that they neglected to discuss the NYSE evidence presented. The NYSE evidence identified that 5 public companies were on the SHO list for an extended period in time based solely on the trading strategies of one options market maker. How is this a healthy situation when one member can be solely responsible for the overselling of 5 publicly traded companies to levels that reach excessive and persistent fails?
Zero tolerance should be the stretch goal of the SEC. It may not be achievable but it must be the goal. The evidence seen before us is clear and the members unknowingly support our argument that the changes in the law will have a minimal impact on those companies not already targeted with the abuses.
By the numbers, 0.18% of all public companies have excessive FTDs due to options market making and 0.8% of all public companies have excessive FTDs due to market making activities. By these standards the changes you propose will have an insignificant impact on the mainstream business they operate. The changes will only have opportunity for positive impacts on the isolated few companies who can fall prey to the abuses.
Dave Patch