The American Stock Exchange
Chicago Board Options Exchange, Incorporated
International Securities Exchange, Inc.
The Options Clearing Corporation
Pacific Exchange, Inc.
Philadelphia Stock Exchange, Inc.
February 9, 2004
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: File No. S7-23-03
Dear Mr. Katz:
The American Stock Exchange, the Chicago Board Options Exchange, Incorporated, the International Securities Exchange, Inc., the Options Clearing Corporation, the Pacific Exchange, Inc., and the Philadelphia Stock Exchange, Inc. appreciate the opportunity to comment on File No. S7-23-03, Short Sales.1 In this release, the Securities and Exchange Commission is proposing changes to the Commission's rules applicable to short sales of securities. Proposed Regulation SHO, Regulation of Short Sales, would replace Rules 3b-3, 10a-1 and 10a-2, and would temporarily suspend short sale price restrictions for specified liquid stocks. Our comments are limited to the impact on options specialists and market makers (referred to collectively herein as "options market makers") of proposed Regulation SHO. As currently formulated, we believe that the proposed rule would significantly harm the ability of options market makers to provide liquidity and narrow quotes in all but upward trending markets. The result would be to harm investors.
These problems derive from three elements. First is the elimination of the exemption from compliance with the NASD bid test for short sales that constitute hedges to bona-fide market making. Rather than eliminating this exemption, we believe that it should be retained and extended to cover exchange-listed securities as well. Second is the proposed uniform bid test itself, which - absent a market maker exemption - will greatly limit the ability of options market makers to sell short and therefore limit their ability to provide liquidity and narrow markets. Third is the narrowing of the locate exemption, imposition of new delivery obligations or short sales, including those that constitute hedges to bona-fide market making, and imposition of a locate requirement as a penalty on the short sales of options market makers if they fail to comply with the new delivery obligation. The new locate and new delivery obligations will hinder options market makers' ability to provide liquidity and narrow spreads with respect to issuers whose common stock is hard-to-borrow.
I. Price Restrictions and the Need for an Options Market Maker Exemption
Proposed Rule 201 of Regulation SHO would replace the current price restrictions found in SEC Rule 10a-1 (the "tick rule") and NASD Rule 3350 (the "NASD bid test") with a single, uniform price restriction (the "uniform bid test") that would require all short sales in exchange-listed and Nasdaq National Market System ("NMS") securities, wherever traded, to be effected at a price at least one cent above the consolidated best bid at the time of execution. Not only would this present a significant change from the current tick rule in the trading of exchange-listed securities, it also would operate differently from the current NASD bid test.
The NASD bid test prohibits NASD members from effecting short sales in Nasdaq NMS securities at or below the best bid when the best bid displayed is below the preceding best bid in a security (i.e., a "down-bid"). But if the best bid displayed is above the preceding best bid in the security (i.e., an "up-bid"), there is no restriction on the price at which a short sale may be effected. The proposed uniform bid test would operate at all times, irrespective of whether the consolidated best bid is a down-bid or an up-bid.
II. The Need for an Options Market Maker Hedge Exemption from the Uniform
The Commission believes that its proposed uniform bid test will "promote the fundamental goals of short sale regulation" by facilitating relatively unrestricted short selling in advancing markets, while preventing short sellers from selling at successively lower prices and accelerating a decline in the market by exhausting all remaining bids at one price level. While we support the Commission's efforts to eliminate or reduce short sales that are intended to destabilize or provide a false impression of the market price for a security, we are concerned about any rule that will reduce liquidity and widen spreads in the options markets. As such, we are most concerned about the lack of an exemption from proposed Rule 201 for short sales effected by options market makers. Such an exemption is currently available in the NASD bid test and we can see no reason why such an exemption should not be included in the uniform bid test.
As noted above, proposed Rule 201 differs somewhat in its operation from the current NASD bid test. Nevertheless, it fundamentally is very much the same. As with the NASD bid test, the proposed uniform bid test uses the best bid as an indicator of the current market for a security, and then limits short sales to a price that is at least one cent above that price. In this manner, the Commission hopes to prevent manipulative short selling, which is designed to destabilize the price of a security and afford short sellers the opportunity to profit from such inappropriate activity. Providing a limited exemption for options market makers seeking to hedge positions acquired in connection with providing liquidity in the options market would in no way run counter to this goal.
The Commission has repeatedly stated that the objective of short sale regulation is to "(1) [a]llow relatively unrestricted short selling in an advancing market; (2) [p]revent short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down; [and] (3) [p]revent short sellers from accelerating a declining market by exhausting all remaining bids at one price level, causing successively lower prices to be established by long sellers."2 Accordingly, the SEC has granted relief from the current tick rule "in specific situations that did not appear to present the opportunity for abuse that the Rule was designed to prevent."3 For example, under Rules 10a-1(e)(7) and (8), short sales in connection with bona-fide arbitrage transactions designed to profit from a current difference between the price of a convertible security and the underlying common stock, and those designed to profit from a difference between the price of a security in the United States and its price overseas, are exempt, even though they are intended to capitalize on temporary price differentials between the related securities or markets. The underlying policy rationale is that the two related transactions result in economically neutral positions.4 The NASD bid test has identical exemptions. Similarly, Rule 10a-1(e)(13) provides that a broker-dealer selling securities that it acquired as a block positioner may disregard, in determining whether it is net long or net short,5 proprietary short positions that are the subject of one or more offsetting positions created in the course of bona-fide arbitrage, risk arbitrage or bona-fide hedging, based on the idea that "[w]here a separate short position . . . is fully hedged, and therefore economically neutral, there is no incentive to effect sales . . . in a manner that would cause or accelerate a decline in the market.".6 All of these exemptions would continue under proposed Rule 201.
Most significantly for purposes of this letter, in 1994 the Commission approved an exemption from the NASD bid test for "exempt hedge transactions" by "qualified options market makers" that are registered with a "qualified options exchange," finding that an exemption for legitimate hedging transactions by options market makers would minimize the potential adverse impacts on the options markets.7
The options market maker exemption was developed during the long process of creation, amendment and approval of the NASD bid test, after a great deal of discussion and analysis by and between the NASD and the options exchanges. After initially submitting its proposed bid test to the SEC in 1992, the NASD met with representatives and market makers from the options exchanges to discuss an exemption for short sales by registered options market makers. The options markets and market makers believed that the NASD bid test would have an adverse effect on the liquidity and pricing of options overlying Nasdaq NMS securities and the ability of options market makers to hedge their options transactions quickly and efficiently in the Nasdaq market.8 The NASD ultimately amended the proposed bid test to provide a limited exemption from the rule for certain short sales effected by options market makers (the "options market maker exemption"). The NASD exception states that a short sale would be permitted for the account of an options market maker that otherwise would be in contravention of the NASD's bid test rule provided the short sales were effected to hedge options positions established as a result of bona-fide market making activity.9
To qualify for the NASD bid test exemption, the short sale must be an "exempt hedge transaction," defined as a short sale that is "effected to hedge, and in fact serves to hedge, an existing offsetting options position or an offsetting options position that was created in a transaction(s) contemporaneous with the short sale, provided that when establishing the short position the options market maker is eligible to receive(s) good faith margin pursuant to Section 220.12 of Regulation T under the Act for that transaction." The short sale must be effected by a "qualified options market maker," which is "an options market maker who has received an appointment as a "qualified options market maker"" for certain classes of stock options . . . pursuant to the rules of a qualified options exchange." A "qualified options exchange" is a national securities exchange that has approved rules and procedures providing for: (1) the designation of qualified options market makers; (2) surveillance of market makers' use of the exemption; and (3) authorization of the NASD to withdraw, suspend, or modify the designation in the event that the options exchange determines that a qualified options market maker has failed to comply with the terms of the exemption and such action is warranted in light of the substantial, willful, or continuing nature of the violation. Each of the exchanges participating in the submission of this letter is a qualified options exchange.
The Commission noted that that in light of the safeguards proposed in conjunction with the exemption, the NASD did not believe that the exemption would "subsume or eviscerate the effectiveness of the NASD's short sale rule." The NASD also noted that the Intermarket Surveillance Group Agreement among and between the NASD and the options exchanges (among others) would "help ensure that the options market maker exemption will not have an adverse market impact on Nasdaq" and would "serve as an effective vehicle for the markets to evaluate possible manipulative activity and other possibly market destabilizing short selling activity by qualified options market makers and other options market makers in Nasdaq securities."10
The justifications supporting the options market maker exemption are no less valid today than they were then. When an options market maker facilitates a customer trade, it may be necessary for the options market maker to hedge its risk by selling the underlying security short. Such short selling is narrowly focused and related directly to a transaction in the overlying option. These trades are neither manipulative nor intended to destabilize the price of the security.
In the nearly ten years since the NASD bid test was adopted, the exemption has permitted options market makers to provide liquidity and depth to the market for listed options by affording them an opportunity to hedge their risk in a meaningful way without regard to restrictions imposed on short selling that were designed to prevent manipulative transactions. Moreover, the limited definition of "exempt hedge transaction" significantly limits the scope of transactions eligible for the exemption and the narrow definition of "qualified market maker" means that only highly regulated and heavily surveilled entities are able to use the exemption. In fact, a 1997 release discussing a study by the NASD Economic Research Department regarding "Economic Impact of the Nasdaq Short Sale Rule," noted that "the American Stock Exchange and the Chicago Board Options Exchange . . . both stated that the options market maker exemption has performed well and that the exchanges have not detected any abuses of the exemption by their members."11 While limited instances of abuse of the exemption may occur - just as they occur with respect to most rules - that does not justify abolishing the exemption. We would not, for example, abolish the ability of emergency vehicles to command the right of way even though, on occasion, that ability is abused or even commandeered with illicit intent. Robust surveillance and enforcement mechanisms exist to detect and punish such violations.
In the Proposing Release, the Commission raises the question of whether a general "hedging" exception should be included in Rule 201, as well as how such an exception could be designed so that it is not subject to abuse. The Commission asks whether such a hedging exception should be limited to a particular group of market participants (for example, option market makers or specialists). We strongly support an exception from Rule 201 for hedging by options market makers. Short sales effected by options market makers to hedge an offsetting transaction in a related security or other financial instrument (such as a listed option) present little threat of the type of downward market manipulation that the short sale price restrictions are designed to address, because any changes caused in the value of the short position generally will be accompanied by offsetting changes in the value of the position being hedged. For this reason, we believe an options market maker exemption could be included Rule 201 without negative market impact.
Bona-fide hedging transactions are not designed to result in lower stock prices, and are not driven by a view that a stock is overvalued or a desire or intent to drive down the price of the stock and profit by covering the short sales at a lower price. Hedging transactions are effected to provide downside protection against the risk of an offsetting transaction -- one that, in the case of options market makers, is effected in connection with bona-fide market making activities (based on the definition of this term proposed in Section III of our comment letter) to facilitate other market participants. The short sales effected by such persons are market neutral. Given that any reduction in the price of the stock sold short would result in an offsetting reduction in the price of the related security that the short seller held long, the hedging short seller has no incentive to depress the stock price, and simply is trying to reduce the risk in the trade in the related security as quickly as possible. This clearly is the case where options market makers are selling short to offset the risk of an options position acquired in connection with bona-fide market making. Moreover, options market makers are subject to several levels of scrutiny and oversight, by the particular markets in which they operate, by the Commission, and, of course, by market participants. Any improper activity undertaken by an options market maker or an imposter would no doubt be quickly noticed and the appropriate regulatory bodies (including the signatories of this letter) would take appropriate action.
In addition, the lack of an options market maker exemption from the current tick rule does not justify omitting such an exemption from proposed Rule 201. At the time the NASD bid test (and its options market maker exemption) were developed and enacted, hedging options positions overlying exchange-listed securities was viewed as more readily accomplished because of the ability to enter a limit order to sell on the specialist's book and be assured an execution at the next possible trading opportunity. The options market makers were concerned that because of the nature of a geographically dispersed competitive dealer market for Nasdaq NMS securities, they would not have the same assurance of an execution.12 Given the sea change in the trading of exchange-listed stocks since that time, which is one of the factors that has led the Commission to propose Rule 201's uniform bid test,13 we believe that an options market maker exemption such as the one currently found in the NASD bid test should be incorporated in Rule 201. Options market makers should be provided with an exemption from proposed Rule 201 in connection with bona-fide market making activities where such transactions, similar to those in the current NASD bid test, are effected to hedge, and in fact serve to hedge, an existing offsetting options position or an offsetting options position created in a transaction(s) that was contemporaneous with the short sale. As with the current exception to the NASD bid test, the exception could be limited to short sales that qualify as "exempt hedge transactions" by "qualified options market makers" in stock options classes for which they have received an appointment as a market maker. The ability to offset risk of an options position acquired in the course of market making by immediately shorting the common stock without concern for price restrictions is critical to providing liquidity in the options markets. By providing such a limited exemption, the Commission would be facilitating activity that is beneficial to the markets and market participants without increasing the risk of manipulative short sale activity that may artificially destabilize the price of a stock, and will "ensure that market-making activities providing liquidity and continuity to the market are not adversely constrained by implementation of the short-sale rule."14
III. Borrowing and Delivery Requirements: The NYSE's Current Market Maker
Exemption from the Locate Rule Should Be The Standard
Rule 203 of proposed Regulation SHO addresses borrowing and delivery requirements for securities. Rule 203(b)(1) contains a uniform locate requirement for short sales of all equity securities, wherever they are traded. This locate requirement is based on current self-regulatory organization rules.15 Proposed Rule 203(b)(1) prohibits a broker-dealer from executing a short sale for its own account or the account of another person, unless the broker-dealer, or the person for whose account the short sale is executed, (1) borrowed the security, or entered into an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that it could borrow the security so that it would be capable of delivering it on the date that delivery is due. Rule 203(b)(2) exempts specialists and market makers from the locate requirement when they engage in short sales in connection with bona-fide market making activities. The proposed rule defines bona-fide market making activities in the negative. Proposed Section 203(b)(2) states that "bona-fide market making activities shall not include activity that is related to speculative selling strategies or investment purposes of the broker dealer or is disproportionate to the usual market making patterns or practices of the broker or dealer in that security." The Commission is seeking comment on whether the market maker exemption is appropriate and whether it should be subject to any conditions.
We support proposed Rule 203(b)(2)'s exception from the locate requirement of Rule 203(b)(1) for options market makers in connection with bona-fide market making activities. As the Commission states, such an exception "is necessary" because specialists and market makers "may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the proposed `locate' rule."16 The Commission's release states that most specialists and market makers try to have a "flat" position at the end of the day.17 In our experience, while most options market makers try to achieve a market neutral position by the end of each trading day, they may not be "flat" in the sense of having no long or short positions or an equal number of long and short positions. An options market maker's overall market neutral position may contain a number of individual stock and options components that may be held over a long period of time in connection with the options market maker's responsibilities as a market maker. The exception to the locate requirements allows options market makers to achieve a market neutral position by the end of each trading day without bearing the potential delays and attendant costs of complying with the locate requirement. Lower costs for options market makers should translate into lower costs for their customers. Further, the exception from the locate rule for options market makers enables these crucial market participants to make tight, liquid markets in the options of hard-to-borrow stock. This is the case because they do not face the risk that they will not be able to comply with a locate requirement for these stocks and, thus, be unable to achieve a market neutral position at the end of the trading day.
We do believe, however, that the definition of bona-fide market making activities in proposed Rule 203(b)(2) is too narrow and inflexible and should be modified. Proposed Rule 203(b)(2)'s definition of bona-fide market making is based on the exception for bona-fide market making transactions contained in NASD Rule 3370, which addresses prompt receipt and delivery of securities (commonly referred to as the "NASD locate rule"). The definition of bona-fide market making activities in proposed Rule 203 differs in a significant way from the definition used in the NASD locate rule. NASD Interpretive Material ("IM") 3350 defines bona-fide market making to exclude "activity that is related to speculative selling strategies of the member or investment decisions of the firm and is disproportionate to the usual market making patterns or practices of the member in that security."18 Proposed Rule 203(b)(2), on the other hand, excludes "activity that is related to speculative selling strategies or investment purposes of the broker or dealer or is disproportionate to the usual market making patterns or practices of the broker or dealer in that security."19
By making the conditions conjunctive, the NASD definition provides options market makers with the flexibility to conduct market making activities while limiting the ability to label truly speculative activity as bona-fide market making. For example, an options specialist or market maker may well engage in transactions that are "disproportionate to the usual market making practices of the broker or dealer in that security" in an options class of an underlying security that is subject to corporate news or other developments. However, this activity may be occurring as a result of increased demand for the options on the security that cannot be met by the regular market makers in the options. Exchanges may encourage other market makers to begin to make markets in the options class to provide liquidity and to meet customer demand. While this activity may well be disproportionate to a particular market maker's usual market making transactions in the options class, it is nonetheless highly desirable because it provides liquidity and satisfies customer demand. Transactions by market makers in these circumstances should not be discouraged. The SEC's proposed definition of "bona-fide market making activity" might well discourage this activity.
The proposed definition in Rule 203(b)(2) limits the ability of options market makers to extend their market making to securities in which they do not normally make markets without providing greater evidence than is required under the NASD rule that this new activity is market making, not speculation. The exception for specialists and market makers in the NYSE locate rule is more rational and provides market makers with the necessary flexibility. NYSE Rule 440C.10 excepts specialists, market makers and odd lot dealers from the NYSE locate rule "in fulfilling their market responsibilities."20 We recommend that the Commission modify the definition of bona-fide market making activities in proposed Rule 203(b)(2) to follow the NYSE model, and exclude from the locate requirement those activities of options market makers that are entered into in fulfillment of their market responsibilities. At the very least, the Commission should modify proposed Rule 203(b)(2) to be consistent with the definition of bona-fide market making found in NASD IM-3350.
Proposed Rule 203(b)(3) contains a delivery requirement for securities that the SEC perceives as having significant settlement failures. The proposed rule imposes additional delivery requirements on securities that have fails at a registered clearing agency of 10,000 shares or more and that are equal to at least one-half of 1 percent of an issue's total shares outstanding. Under the proposed rule, delivery for short sales for any security meeting this threshold must occur within 2 days after settlement date (as opposed to 10 days under the NASD Rule). If the security is not delivered within this time, the proposed rule would restrict the broker-dealer, including any market maker, from executing further short sales in the security for the account of the person for whose account the failure to deliver occurred (including the broker-dealer's own account in the case of a proprietary short sale) for 90 days unless the broker-dealer has borrowed the security, or entered into a bona-fide arrangement to borrow the security, prior to executing the short sale, and will deliver the security on the date delivery is due. In addition, (1) the clearing agency must refer the broker-dealer that failed to NASD and the broker-dealer's designated examining authority and (2) the clearing agency must withhold a benefit equal to any mark to market amounts or payments that otherwise would be made to the participant failing to deliver and assess appropriate charges. Rule 203(b)(3) contains no market maker exemption.
We strongly believe that the Commission should include an exemption from the delivery requirements in proposed Rule 203(3) for options market makers in connection with bona-fide market making activities. NASD Rule 11830, on which proposed Rule 203(3) is based, contains such an exemption for bona-fide market making transactions, and the Proposing Release sets forth no explanation as to why proposed Rule 203(3) should diverge from NASD Rule 11830 in this important respect. While the Commission states that the reason for extending the rule to market makers is based on its belief that "extended fails to deliver appear characteristic of an investment or trading strategy, rather than one related to market making," the Proposing Release provides no data to show that options market makers are responsible for significant failures to deliver in the securities covered by Rule 203(3) or that their sales were not hedges to market making.
Without an exemption for option market makers, we are concerned that the effect of proposed Rule 203(3) would be to cause options trading in thinly traded securities to cease altogether. Specialists and market makers would most likely be restricted by their clearing firms from trading hard-to-borrow securities. These restrictions would make it impossible to hedge exposure arising from their market making activities. No prudent options market maker would make markets without the ability to hedge. There are many thinly traded equity products that currently support healthy options markets largely due to options market makers' flexibility to access liquidity in the underlying marketplace when such opportunities present themselves. In many instances, that flexibility gives options market makers the ability to provide liquidity to the marketplace when liquidity in the underlying security is poor or nonexistent. Even if proposed Rule 203(3) does not completely shut down options trading in thinly traded securities, it will certainly impair the ability of options market makers to make market in these options and increase costs to investors. Given the critical role of options specialists and market makers in providing liquidity and tight markets, and their need to hedge exposure through short sales, their bona-fide market making activities, as we propose they be defined in connection with Rule 203(b)(2), should be exempt from Rule 203(3).
* * *
Thank you again for the opportunity to comment on proposed Regulation SHO. If you would like to discuss any of the issues raised in this letter, please contact Susan Milligan at The Options Clearing Corporation at (202) 756-1972.
The American Stock Exchange
Chicago Board Options Exchange, Incorporated
International Securities Exchange, Inc.
The Options Clearing Corporation
Pacific Exchange, Inc.
Philadelphia Stock Exchange, Inc.
cc: Annette Nazareth
|1|| Securities Exchange Act, Release No. 48709 (October 28, 2003), 68 Fed. Reg. 62971 (November 6, 2003) (the "Proposing Release").
|2|| Notice of Adoption of Amendments to Short Selling Rules, Securities Exchange Act Release No. 11468, 40 Fed. Reg. 25442, 24443 (June 16, 1975) (footnote omitted); accord Proposing Release, 68 Fed. Reg. at 62980.
|3|| Concept Release on Short Sales, Securities Exchange Act Release No. 42037, 64 Fed. Reg. 57996, 57997-98 (Oct. 28, 1999) (the "Concept Release") (footnote omitted).
|4|| See Concept Release, 64 Fed. Reg. at 58001. Ironically, under Rule 201 as proposed, short sales by options market makers effected simply to hedge risk assumed in providing liquidity to the market would not be exempt from the uniform bid test, while arbitrage transactions, which are designed to yield a profit from certain market inefficiencies, would be exempt.
|5|| SEC Rule 3b-3, which defines the term "short sale," provides that "a person shall be deemed to own securities only to the extent that he has a net long position in such securities."
|6|| Application of Rule 10a-1 to Certain Sales by Block Positioners, Securities Exchange Act Release No. 20715, 49 Fed. Reg. 9414, 9415 (Mar. 13, 1984). Similarly, the Commission has provided relief from the tick rule for sales by broker-dealers that are unwinding long index arbitrage positions, where the sale of stock is deemed a short sale because the firm elsewhere holds short positions in the same securities established in the course of bona-fide arbitrage, risk arbitrage or bona-fide hedging activities. Again, because such positions are economically neutral, the broker-dealer would have no incentive to engage drive the stock price down, and the unwinding of the index arbitrage position is not viewed as involving the abusive short selling that Rule 10a-1 was designed to prevent. See Liquidation of Index Arbitrage Positions, Securities Exchange Act Release No. 27938, 55 Fed. Reg. 17949 (April 30, 1990).
|7|| Securities Exchange Act Release No. 34277, 59 Fed. Reg. 34885 (July 7, 1994); see also Securities Exchange Act Release No. 33289, 58 FR 64994 (December 10, 1993). This exemption was further extended to certain NASD members that are not options market makers on a qualified exchange but that provide liquidity to this marketplace. See NASD Notice to Members 94-83, Q&A 7 (September 1994).
|8|| Securities Exchange Act Release No. 31729, January 13, 1993.
|9|| Securities Exchange Act Release No. 33289, 58 Fed. Reg. 64994 (December 10, 1993).
|11|| Securities Exchange Act Release No. 38979 (August 26, 1997).
|12|| See Securities Exchange Act Release No. 31729, January 13, 1993.
|13|| See generally Proposing Release, 68 Fed. Reg. at 62979-62980.
|14|| NASD Notice to Members 94-68.
|15|| See NYSE Rule 440C.10 and NASD Rule 3370.
|16|| 68 Fed. Reg. at 62977.
|18|| NASD IM-3350(a)(3) (emphasis added).
|19|| 68 Fed. Reg. at 63009 (emphasis added).
|20|| NYSE Rule 440C.10.