December 22, 2003
Mr. Jonathan Katz
I am writing in protest of the proposed Short-Sale rule amendments under Regulation SHO. There are many reasons why the proposed changes are negative, but I will highlight a few critical reasons. Ultimately, the rule tries to protect prices against volatile and violent downward price movements, but in reality, the measure can only be a valid and practical method in the mind of regulators with no experience in the capital markets. There is absolutely no choice but to dismiss this idea as a curious pipe dream with a benevolent purpose, but little practical utility.
First, in New York Stock Exchange stocks it is impossible to allow short sales effected at a price one cent above the best consolidated bid. The specialist system used in that exchange centers around spreads set by the specialist to create and order the market -as they see it. As highlighted in recent news stories, the specialists face lawsuits and scrutiny because, without a doubt, the specialists act contrary to overall market movements and most often in their own best interest. You cannot short one cent above the consolidated best bid because there is only one bid and one offer. There is zero chance of ever being able to short on a specialist-determined ask/offer because, in my experience as a professional trader, the specialists will not give you an execution if it will benefit you. Hence, the probability of obtaining an execution on the short side will realistically drop to nearly zero, and that is a fact. Regulation SHO ignores market realities such as this. However, the reason why the proposed rule is invalid, because executions cannot be obtained by investors looking to sell stock, is precisely the reason why the Small Order Execution System was originally mandated.
SOES, and later Super Montage, was created for that exact purpose, to allow investors and individual traders, such as myself, to get executions despite their small size and lack of billion-dollar buying power, like the major investment banks. SOES was a brilliant step in the right direction of furthering price liquidity and freedom of movement in our capital markets. It is exactly the reason why foreign firms invest and trade in our marketplaces -because of the pure capitalistic freedom of stock prices. Alternatively, Regulation SHO runs contrary to all these benefits of our markets by making it statistically more difficult to sell stock than buy stock. Stock markets are cyclical, they go up and down in value, and prices fall just as often as they rise. Trying to legislate and regulate a fixed-barrier to price declines is not only unreasonable and infeasible, but also inherently contradictory to the nature of capitalism and the capital market system. Buyers and sellers have varying opinions about the extent of prices changes and the time-horizon in which they occur. The Securities and Exchange Commission cannot remove the liquidity and free nature of prices modeled under the SOES system. Rather, the SEC should acknowledge the balancing-act nature of buyers and sellers in the market, and allow the actual market participants to determine prices, rather than self-motivated specialists and indifferent market makers with multiple-million share orders who inefficiently influence and block price movements.
If a short sale can only be affected one-cent above the consolidated best bid, then the average small investor or small investment house is held at the mercy of larger banks and trading firms who act in their own self-interest. If a major investment bank has a large buy-order to purchase several hundred thousand shares in a stock that, like most, only does several hundred thousand shares volume per day, then that bank can entirely and completely become the market movement in that stock. For example consider the following: bad news comes into the public eye regarding entertainment stocks. Traders and investors look to sell a small-to-medium volume publicly traded company. However, a large investment firm has an order that day to buy a large quantity of that stock. The investors begin trying to sell, and the investment firm begins buying. The investment firm, with an order many multiples larger than those of the investors, stays on the inside bid continuously buying stock. The investment firm refuses to drop its bid, as usual, and holds the stock in a virtual flat-line price chart for several hours. The entire time, the investors and small firms are selling to the large investment firm. After some time, the sellers, who cannot match the immense financial resources of the investment firm, exhaust their selling. The investment firm no longer has any sellers for the stock, of which it still must buy several hundred thousand shares. The investment firm must now begin raising its bid in an effort to attract more sellers. The result: while prices should have gone down due to the negative news about the entire entertainment sector, instead they went up! The next day the stock plunges twice as far as it should have, because it was inefficiently overbought. The reason: if short-sales cannot be effected at the inside bid, prices can be held and fixed by large orders in almost every single stock except only the most liquid stocks (which make up a very small fraction of the overall number of stocks held by investors today). Regulation SHO would encourage and technically facilitate such price inefficiencies. In my experience as a professional equity trader, this is the unfortunate reality that the rule change would create. It is unrealistic and impractical and must be rejected.
In summation, while the regulation seeks to protect stocks from downward movements in prices, the SEC must realize that prices do decline, and that declines are both healthy and a constant factor in our capital markets. Overbought stocks must be sold off to keep their prices on a sustainable level, and oversold stocks are bought up to capitalize on undervalued and under-appreciated investments. Just as quickly as prices decline one day, the market "buys on dips" the next and we rally to new highs. This is the true reality of our capital markets and based upon the free and unrestricted movement of prices in our system. The SEC must resist and reject any and all efforts that run contrary to the pure capitalism that exists as a cause and product of the freedom of prices.
Daniel S. Silver