Securities and Exchange Commission:
Dear Mr. Katz,
Re: File #S7-23-03
I just received an inquiry from a U.S. micro cap investor asking me just how long things on the smaller trading venues in the U.S. markets, namely the Over the Counter Bulletin Board (OTCBB) and the Pink Sheets, have been this far "out of whack". My answer was that they've always been very "loose" but since "decimalization" came into being a few years ago, things have spiraled out of control. Decimalization has lessened the "spread" between the bid and offer of these securities significantly. Since market makers live "off of the spread" their earnings have been negatively impacted. Since the shareholders of the large publicly traded market-making firms have grown accustomed to certain levels of earnings, the pressure is on these firms to make up for the earnings lost to decimalization's deleterious effects.
Historically the role of the market maker was seen as two-fold. He was to bring together those wanting to buy shares of a specific issuer with those wanting to sell these same shares. In the absence of one or the other, the market maker would step up to the plate and fulfill the role of the missing party in an effort to inject liquidity into these markets. In so doing, he would take on demonstrable risk. After selling nonexistent shares into a buy order that appeared when no sellers were around, this "bona fide market maker" would then attempt to repurchase these shares at a slightly lower level and pocket the difference or "the spread". He would thus be "injecting liquidity" onto both the buy side and the sell side and the risk that he assumed was mitigated by his superior visibility of buy and sell orders and his ability to capture this "spread". Thus the prototypical "bona fide market maker's" role was to provide a "forum" for buyers and sellers to interact, and to be willing to inject liquidity TO BOTH BUYERS AND SELLERS when one or the other was missing at any specific time. In so doing he did indeed assume demonstrable risk.
In exchange for this assumption of risk and to implement the performance of a "bona fide market maker`s" role, the regulators ENTRUSTED upon a bona fide market maker while acting in a bona fide market making capacity, and ONLY to these ROLE PLAYERS, the privilege to be able to sell nonexistent shares into a disparity involving an excess of buy orders coincident with a dearth of sell orders (NASD RULE 3370). He was to then quickly cover this naked short position by going onto the bid for a like amount of shares. THE ASSUMPTION MADE BY THE REGULATORS WAS THAT ALL MARKET MAKERS ENTRUSTED WITH THIS GIGANTIC AND INCREDIBLY EASY TO ABUSE PRIVILEGE WOULD ACT IN GOOD FAITH.
So what went wrong? Unethical market makers and their co-conspiring clearing firms, hedge funds, Canadian broker/dealers, naked short selling consortia, and other "associates" realized the tremendous amount of money that could be "earned" by leveraging this "privilege" and sharing the space under this "umbrella of immunity" from the necessity of borrowing shares before selling them. What this, and the knowledge of the existence of several other loopholes in the system, has resulted in is the ability of these co-conspirators to sell nonexistent entities to U.S. micro cap investors, take their money, and to sit on the resultant "failures to deliver" or loans made to mask these "fails" for a prolonged amount of time while the victim U.S. corporation slowly died from the resultant massive dilution caused by the presence of these "counterfeit shares" in the system and their ability to be sold at any instant in time.
In a nutshell, the balance between the risks taken by a market maker and the privileges granted to the market maker for the assumption of that risk, has been lost. This was caused by what my book refers to as "the onset of one-sided liquidity only". What happened was that the unethical market makers were always there to inject liquidity by selling nonexistent shares into an imbalance of an excessive amount of buy orders, but they were conspicuously absent when the imbalance became that of too many sell orders. Addressing this imbalance would necessitate the spending of the incredibly large pile of investors' money in front of them that they "EARNED" from selling nonexistent entities. So much for the regulators' assumption of "ACTING IN GOOD FAITH". There was just too much "Free investors' money" in the system to fight off this temptation.
Thus the liquidity being provided is not 2-sided liquidity that leads to the two main benefits of legal short selling, that being 2-sided liquidity and increased market efficiency. And how about the demonstrable risk being assumed in exchange for the right to sell nonexistent entities into buy-side imbalances? Let me answer that with a question. How much risk is there in shooting these micro cap "fish" in the barrel provided by the OTCBB and Pink sheets? In this computer age do we really need a middleman to bring a buyer and a seller together? Do we need "one-sided liquidity only" being provided by somebody entrusted with the power to introduce counterfeit shares into the system? Does the term CONFLICT OF INTEREST apply here? Have these trading venues, in essence, been hijacked by the middlemen and their coconspirators and converted into their own cash machines at the expense of the mom and pop investors? Cannot a willing buyer seeking "real" shares interact with a willing seller in possession of "real" shares, without a middleman, even though the market would be less liquid and the buyer might have to pay slightly more per share? (A "real" share only market) Is the ability to easily buy counterfeit electronic book entries of a U.S. corporation being pushed off a cliff really what "liquidity" is all about?
So what are we left with? We are now left with the perpetrators of these frauds sitting with a gigantic pile of U.S. micro cap investors' money in front of them as well as trillions and trillions of "counterfeit" shares or more accurately, "counterfeit electronic book entries" sitting in the "D" sub accounts at the Depositary Trust and Clearing Corporation in New York City, within "in house" proprietary accounts at unethical brokerage and clearing firms, and within the Canadian brokerage system as well as other offshore non-NASD brokerage firms and banks.
What's the solution? The solution is to force those with the investors' money in front of them to deploy those very same funds and immediately buy back out of the open market the shares that they previously sold but never owned so that no other U.S. micro cap corporations will become insolvent from the weight of those counterfeit electronic book entries that unfortunately can be sold at any instant in time. Remember that the exemption from borrowing before selling is only legally accorded to market makers while acting in a bona fide market making capacity i.e. sell then immediately repurchase. If there are no gigantic naked short positions in existence as reported by the market making community, then there will be nothing to buy in, right? What's the risk to the SEC or the members of Congress that oversee the SEC, should the SEC fail to act, in demanding the immediate buy-in of these nonexistent entities?