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Mr. Jonathan G. Katz
Charles William Hansford
Dear Mr. Katz: I am writing you to protest the "Bid Test" proposal of the pending Regulation SHO (Reg SHO). By passing this regulation, that would force short sales to be affected at a price one cent above the consolidated best bid, the SEC would:
As a 10-year professional in both the domestic and international financial markets and a student of Economics, I hope to convince you that the Reg SHO will have detrimental effects on the marketplace and that the SEC's shorting policies should be liberalized and loosened to match the modern and high-paced marketplace that exists today. REGULATION SHO WOULD FOSTER AN INEFFICIENT MARKETPLACE Reg SHO's best bid short selling proposal would inhibit a stock's ability to reach a temporary equilibrium price in a truly efficient manner. As stated in the SEC's 17 CFR Parts240 and 242 Short Sales; Proposed Rule; "Short selling provides the market with at least two important benefits: market liquidity and pricing efficiency." Short selling liquidity is already limited by the present short-selling rules. The Reg SHO best bid proposal would further constrict this pool of liquidity, which is vital to the proper short-term equilibrium price of a stock - especially when news on a stock breaks. You have to understand that a stock's price efficiency cannot be simply determined by the "long" position stockholders because they do not represent all of the market's participants. By taking into account speculative short sellers, the stock is able to truly reach a short-term equilibrium price in a quicker and more efficient fashion. This is true in both Bear and Bull markets. While most politicians and non-market participants do not appreciate, and if anything distain, the role of short sellers, this does not diminish the importance and vital contribution short selling adds to today's equity markets. It is disappointing to read in the SEC's Reg SHO report about how short sellers today are still seen the same light as the "bear raiders" that existed nearly 80 years ago during the 1929 financial crisis. To use this "bear raider" history as justification to limit the short sellers participation in the markets is to demonstrate a clear misunderstanding of how stocks are priced and valued. I wish I knew of recent examples of "bear raid" of a relatively problem-free, well-operated company, because I would buy ever single undervalue share possible - as would most of the Street. In any case, such "bear raid" tactics can only reap the difference between the price of the short and zero; whereas the risk involved is unlimited given that the stock can rise to any price. The reality is that the participant in a "bear raid" or just a normal short position has a lot more to worry about than the system does regarding their short selling participation in the marketplace. Placing restrictions on after-hours trading and short-selling limitations during severe market declines (over 10%) will not stabilize the market nor make it more efficient. It more likely that such proposals will restrict participation and liquidity and create imbalances that only larger financial institutions will be able to take advantage of; further marginalizing the role of the individual investor. WORSEN WHAT IS ALREADY AN UNFAIR PLAYING FIELD FOR INDIVIDUAL INVESTORS I find it peculiar that the individual investor is unhindered to profit from an upwards stock move whereas the same individual investor has to navigate a series of regulations and rules to benefit from a downwards stock move. Where large financial institutions are able to protect themselves and profit from negative moves in stocks via sophisticated financial hedging products, most individual investors do not have the financial resources or the understanding of these products' nuisances to take advantage of such strategies. Instead, the individual investor depends on his/her participation in the equities markets through rather vanilla "long" and "short" positions. Why should the individual investor be limited in his/her ability to take advantage of downwards moves in stocks while institutional investors and market makers are able to do the same not only in the equity markets (which will be addressed in the next section) but also in the related hedging markets? For example, when news hits the market, let's say about the chip industry, and Mrs. Jones (an individual investor) wants to quickly short a certain chip company to hedge her long-term position in another chip company, why isn't she able to simply do so, even in a downward move? The proposed Reg SHO would utterly prevent Mrs. Jones from executing this simple financial strategy in a timely fashion. She would have to wait for a upwards move in the stock, which could be points away from when she heard about the news and which often signals the bottom of the move - which could be the last place Mrs. Jones would want to get short. Not only would this rule potentially prevent a Mrs. Jones from hedging herself in the short-term but also if she went through with the strategy at a lower price, she might end up actually losing money because of her inability to enter the short sale at an appropriate level. TRADING REALITIES OF THE REG SHO: MARKET MAKERS CONTINUE TO HAVE THE UPPERHAND OVER THE INDIVIDUAL INVESTOR The proposed Reg SHO would create an even more adverse trading climate for the individual investor. This can be demonstrated through a short example. In this situation, good news is released about ABCD stock and the market pushes its price up $10 over a five-minute period. The individual investor is able to profit from his/her long positions, and during this up-move, speculate by shorting the stock on each up-tick. During the sixth minute, news comes out that the previous "good" news isn't as good as it was to be believed. (This type of news reversal is rather commonplace in the equity market.) The stock begins to plummet back to the price where it came from, yet in this part of the scenario, the individual investor is helpless and unable to benefit from this down move unless there is an up move. Most individual investors who bought the stock are competing to hit bids with market makers that are clearing levels of stock deep through the bids in order to fill orders for their "clients" (read: THEMSELVES). So not only is the individual investor not able to make money short during the down move, but the long-positioned individual investor gets hurt as market makers get short by aggressively hitting through the bids. Additionally, the Reg SHO proposal does not take into account that the liquidity is not always at the inside market. In less liquid stocks often the sizable bid is a couple of pennies away from the inside market. By restricting the short sale of stock to a penny above the best bid, how are individual investors able to access the larger size below this level? How come market makers will have access to this liquidity but individual investors do not? Frankly, even if the size (let's say 20,000 shares) is at the shortable price level, all a market maker will have to do is go a penny high on the bid and essentially lock out that size from being shorted by non-market maker participants. Not only does this make the market less efficient but also it is absolutely unfair for the savvy individual investor. SOME RETORICAL QUESTIONS
CONCLUSIONS First of all, the SEC should realize that Bear and down markets are no worse or better than Bull and up markets. They are both natural occurrences and both subject to excessive selling and buying. (Which the SEC doesn't seem interested in restricting...) Secondly, the SEC should embrace this reality and place the same restrictions that exist for buying stock on selling stock - that is none. This would create a truly dynamic and efficient marketplace where the individual investor and larger players would truly be on an even playing field as far as applying long/short strategies is concerned. While the pilot program to permit shorting in a basket of several hundred stocks is a good first step, it should be expanded to include all stocks. Finally, if the SEC is interested in preserving the integrity of the marketplace, it should really focus on the illegal insider trading (often with the participation of market makers) that cause many of these excessive up and down moves and that inevitably hurt the individual investor "outsider". I hope you take the above comments into consideration and reject the "bid test" proposal of Reg SHO. Thank you for your attention. Sincerely, Charles William Hansford |