James J. Angel, Ph.D., CFA
Associate Professor of Finance
McDonough School of Business
Georgetown University
Room G4 Old North
Washington DC 20057


Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street NW
Washington, DC 20549-0609
January 3, 2004
File No. S7-23-03

Dear Mr. Katz:

Here are my comments on the proposed Regulation SHO. In brief:

  • I support the idea of a uniform rule across all securities and all trading platforms.

  • The bid test should apply only for prices below the previous day's closing price - there is no need to inhibit short selling when stock prices are rising.

  • The pilot is a great idea, although the pilot should start with the new bid test first.

  • The data needed to judge the success of the pilot should be made widely available for researchers on the web.

  • The distinction between bona fide market making and speculative trading is highly flawed and should be replaced with a blanket exemption for bona fide market makers who quote at the inside at least five percent of the time.

  • The failure-to-deliver problem is an artifact of the lack of supply of lendable shares due to Reg T's restrictions on margining OTC stocks below $5. The SEC should work with the Fed to resolve this problem.

  • The affirmative determination rule is unnecessary if there are sufficient penalties for failing to deliver.

  • The extension of the delivery rules to all markets makes sense, although the market maker exemption from the affirmative determination rule is essential.

  • More data should be disclosed to investors about failures to deliver and short sales.

My detailed comments are attached.


James J. Angel

Reg SHO: File S7-23-03

Comments by

Professor James J. Angel, Ph.D., CFA
McDonough School of Business
Georgetown University

My background:

I am currently an Associate Professor of Finance at Georgetown University. I have conducted academic research in the area of short selling, and was gratified to see some of my work cited in the proposing release. I have previously been the Visiting Academic Fellow at the NASD (1999-2000), and a former chair of the Nasdaq Economic Advisory Board. I am also a member of NASDAQ's OTC Bulletin Board Advisory Committee. I have visited over 35 exchanges around the world and sat on numerous trading desks. However, my comments are my own and do not necessarily reflect those of Georgetown University, NASDAQ, or anyone else. I have not received any compensation for these comments.

General comments:

A uniform rule is better than the current system.

Clearly, this is a good time for the Commission to address the problems with the existing regulation of short selling. There is a widespread perception that abusive naked shortselling is a problem. Decimalization has turned the current uptick rule into a farce. The current rule is so easily evaded that it is useless, yet it imposes significant compliance costs on the law-abiding members of the industry. The bid test will be simpler and easier to implement.

In the NASDAQ-listed world, the large market share of UTP exchanges (which have no bid test or uptick rule) leads to a very unlevel playing field. The NASDAQ short sale rule applies to trades on NASDAQ, but not on the UTP exchanges such as the National Stock Exchange or the ArcaEx that print trades in NASDAQ-listed stocks

Clearly, a uniform rule that applies across all trading platforms in a given security is long overdue.

Part I: The Bid Test

Is a bid test needed with strong delivery rules?

The Commission is wise to explore in the pilot the possibility that the delivery rules may be sufficient to deter alleged abuses of short selling, and we may not even need a bid test. Indeed, there has been a natural experiment going on for the last several years in the NASDAQ Small-Cap market. NASDAQ's existing affirmative determination and delivery rules apply to Small-Cap securities, but the NASDAQ Short Sale Rule does not. Although I have not yet completed a formal study of this, my anecdotal observation is that most of the alleged abuses are in the OTCBB market and not the NASDAQ Small-Cap market. This to me is strong evidence that the delivery rules are far more important than a bid test in preventing abuses. However, a uniform rule is better than the incoherent hodge podge we have now.

The bid test should not apply at prices above the previous close.

One problem with the proposed bid test is that it applies at times when the stock is rising as well as when it is falling. Since the first stated objective of the rule is "allowing relatively unrestricted short selling in an advancing market," it makes no sense whatsoever to apply any kind of restriction on days when the stock is rising. Indeed on such days one should make short selling easy for all of the usual reasons to dampen market volatility.

Restricting short selling in up markets just makes it easier for market manipulators to pump up stocks prior to dumping them.

For this reason, the Commission has a duty to make short selling as easy as possible in up markets, and should not apply the bid test at times when the stock's price is above the previous day's closing price.

Indeed, the proposed test is highly restrictive, even in up markets. It effectively prohibits the immediate execution of any market short sell order, but effectively converts such orders into limit sell orders with limit prices that float one cent above the bid. While the execution delay in an up market may not be noticeable for an active stock, there could be substantial delays for inactive stocks.

Legitimate specialists and market makers should be exempt from the bid test.

The distinction in the proposal between "bona fide" market making and speculative trading reflects a fundamental misunderstanding of the vital role that specialists and market makers play in the markets. The proposal views market making similar to oversimplified academic models from a generation ago. In this cartoon image, the market maker is a totally passive entity who posts quotes to attract anonymous order flow. If the market maker's inventory gets out of balance, then the market maker adjusts her or his quotes to attract offsetting order flow and does nothing else.

In this oversimplified view, market makers always "go home flat" with a zero net position. However, this is not always possible, especially in thinly traded microcap stocks.

In real life, market making operations are much more complex and market makers are not, and should not be, passive entities. Recall that the two basic functions of a market mechanism are to:

  1. Match buyer and seller, and

  2. Discover the price.1

It is the job of the specialists and market makers and operators of trading platforms to help the markets with both of these functions, matching and price discovery. At times, this requires active trading in addition to passive trading.

For example, holding short positions to offset long positions in other stocks helps market makers manage their risk. A market maker may discover (perhaps as a result of auto-ex guarantees) that he is suddenly long a large number of shares in a relatively illiquid small biotech stock. It will take some time to reduce the inventory efficiently, leaving the market maker exposed to lots of unwanted risk to the biotech sector as well as to the idiosyncratic risk of the stock itself. The market maker may want to actively short other, more liquid biotech stocks as a fast hedge against the long position in the original less liquid biotech stock.

Market makers may also want to be short stock to hedge their overall market risk and thus be more "market neutral." After all, their comparative advantage is in market making, not predicting long-term stock market movements. The ability to hedge market risk makes market making less risky, attracting more market makers and thus allowing competition to reduce spreads.2 Again, with their inventory fluctuating wildly, market makers may wish to actively and quickly short some stocks to maintain a market neutral position. Although other hedging vehicles such as futures exist, they do not always provide the best hedging tool because of execution lags and transactions costs.

One way to think of the role of the market maker is that of a retailer like a grocery store. Customers come to the grocer because they expect to get fast service at a good price. The job of the grocer is to make sure that he or she has the inventory needed to satisfy customers. However, grocers have limited capital and limited shelf space, so they cannot hold unlimited inventory. Part of the job of the grocer is to anticipate customer demand and thus have the right amount of inventory. So, if the grocer anticipates high demand for Thanksgiving turkeys, the grocer will order more in advance. Running out of inventory is bad for the grocer because is imposes hardships on the customers who are sent elsewhere to purchase at a higher price.

Good market makers help to smooth market volatility by correctly anticipating demand. If they anticipate that customers will be buying, they stock up on inventory in anticipation. If they do not stock up in advance, a wave of customer orders will quickly push the firm against its position limits. When the firm's position limits are exhausted, it then routes the orders elsewhere to chase whatever liquidity can be found elsewhere at whatever price. By having the inventory ready, they can smooth out the air pockets in real order flow and thus help to produce smoother and more accurate prices. This need to proactively position themselves applies just as much to the short side as it does to the long side of the market.

Some might criticize that such active trading by a specialist is "speculative." However, all market making could be called speculative. The market makers and specialists attempt to buy low and sell high, just like other investors. This applies to passively responding to customer market orders just as it does to more active trading. There is nothing wrong with that.

NYSE specialists did not need an exemption from the old uptick rule because they generally had control over the tick and could engineer an uptick whenever they wanted to. The NYSE uptick rule only applied to NYSE trades. However, in the new consolidated world, specialists may discover that they, too, will need the flexibility that an exemption would give them.

There is nothing inherently wrong with special privileges for specialists and market makers. Market makers provide a service to the world by providing two-sided quotes throughout the trading day. Indeed, the action of posting a bid quote is effectively giving a free put option to world, and posting an ask quote is giving away a free call option. These options have value. Unless there is some offsetting advantage, fewer market participants will shoulder the burdens of being a market maker. Many stock markets around the world provide incentives for liquidity providers to post quotes, ranging from reduced fees to preferential access to trading facilities.

The Commission has a legitimate concern with exemptions for market makers. If market makers are exempt from the rules, then day traders and bear raiders who do not provide any meaningful liquidity will register as market makers for the sole purpose of taking advantage of the market maker exemptions. They will enter meaningless quotes such as $0.01 bid/ $2,500 asked while making use of the systems designed for real liquidity providers.

This concern can be addressed by exempting bona fide market makers from the bid test. One definition of a "bona fide" market maker would be one who quotes at the inside quote at least 5% of the time in over 75% of the stocks in which they make markets. This would give market makers the incentive to quote aggressively.

Indeed, it is far easier to define bona fide market makers than it is to define bona fide market making trades. Attempting to go through each trade of a market maker and figure out whether it is a bona fide market making trade will be an enforcement and compliance nightmare.

Midpoint matching systems should be explicitly exempt from the bid test.

Although the proposing release asserts that passive crossing systems such as POSIT would not be affected by the bid test, this will not always be the case. For example, if the bid-ask spread is only one cent, the matching price will only be one half cent above the bid, not one cent. Since it is impossible to use a passive matching system like POSIT to implement a bear raid, such systems should be explicitly exempt.

The arbitrage exemption should be broader.

I see no reason for the Commission to draw the definition of arbitrage activity as narrowly as it has. It is highly unlikely that bear raiders would use index arbitrage trades to attack a particular stock.

The bid test depends on the quality of the BBO data feed, which is deteriorating over time.

The Commission should be aware that the Commission policies have led to fragmented markets in which crosses, locks, and trade throughs have become more common. This is leading to a deterioration of the quality of the BBO data feed. Because this rule, and the best execution rules rely on a high quality BBO, the Commission should consider the quality of the BBO a high priority as it sorts through the whole market data quagmire.

The bid test is problematic for penny stocks.

As proposed, the bid test requires short sales to take place one cent higher than the bid. However, for very low priced stocks, this requirement may require short selling to take place at a price higher than the offer price. Even though the NYSE and NASDAQ generally do not list stocks below $1, stocks sometimes trade below a dollar prior to delisting. For this reason, the bid test should require the prices to be one tick above bid, not one cent.

The bid test should not apply after normal trading hours.

Despite the fact that some systems are open for trading outside traditional market hours, in reality a very small amount of trading takes place at those times. Most of what little after hours trading there is takes place in the minutes just before the open and just after the close.

During the pre-open period, locks and crosses are quite normal, making the application of the new bid test extremely problematic. There is often considerable uncertainty as to which quotes are valid and which are stale. I recommend starting with the new rule during normal trading hours, and then taking a "wait and see" attitude to whether it should be extended outside normal trading hours.

Despite my support for the bid test (with my suggested modifications), I think that it does have some drawbacks:

The bid test will be easily evaded with supernormal commissions.

It will be trivially easy for a bear raider to evade the bid test: All they will have to do is arrange to pay one or two cents extra in commission for immediate execution. The brokerage firm eagerly complies and fills the order at one cent above the bid and covers by hitting the bid. The brokerage firm is happy to do this because the commission on the sale is more than the one cent loss on the trade. The Commission may wish to add some language to the rule to prevent such abuses from higher than normal commissions.

The bid test will encourage markets to be less transparent.

The bid test effectively converts market short sell orders into limit short sell orders that are one cent above the bid. The only time that a market short sell order will get immediate execution is if there is undisplayed trading interest. This will give markets that lack transparency a competitive advantage in attracting short sellers, and could encourage markets to promote hidden orders. The Commission should monitor this as part of the pilot experiment to see if it becomes a problem.

Part II: Locate and Deliver rules

Clearly, pathological situations in which failures to deliver can double the shares outstanding need to be addressed. These abuses of "naked short selling" mainly occur in the OTC market. In crafting rules to address this problem, the Commission should look at the larger picture.

One of the big problems in OTC market is a shortage of lendable stock.

One major problem is that the securities lending market does not function efficiently in the microcap sector. In general, OTC stocks less than $5 are not marginable under Federal Reserve Regulation T.3 This means that the supply of such shares for borrowing is quite limited. Furthermore, the lack of institutional interest in the microcap sector means that the securities lending programs run by large custodian banks also do not add much to the supply of lendable stock.

This lack of lendable supply makes it harder to locate shares, leading to more and longer failures to deliver. This lack of supply also makes it very difficult for individuals to short OTC stocks.

The SEC should ask the Fed to fix Regulation T.

The real solution is to amend Regulation T to make all stocks marginable. The Fed's natural concerns about the quality of microcap stocks as margin collateral can be addressed without a total ban on marginability. The Commission should call on the Board of Governors to fix this obsolete provision in Regulation T.

The SEC should also make it easier to lend fully paid stock from non-margin as well as margin accounts.

My understanding is that many brokerage firms interpret the SEC's hypothecation rules to mean that firms may not lend out fully paid for securities. I see no reason why fully paid shares should not be lendable as long as investors are suitably informed and can opt out if they so desire.

The location rule is redundant if there are sufficient penalties for failing to deliver.

Severe penalties for non-delivery would provide a good incentive to locate shares before shorting. However, until the inefficiencies in the stock lending market described above are fixed, the penalties should not be too draconian.

Applying the location rule to the OTCBB is a good idea.

The location rule will help to deter abusive naked short selling by making shorts locate the shares before actually shorting. This is a good idea and it will inhibit the creation of phantom stock through naked shorting.

The market maker exemption is extremely important in the OTC and should be broader.

As the Commission points out, applying the location rule to market makers would make is difficult for them to carry out their legitimate market making activities. However, the narrow nature of the proposed exemption is problematic.

Market makers play a strong position in promoting pricing efficiency in the OTC world. Because individuals find it difficult to short, the market makers have even more of an obligation to sell short when needed in order to keep the price reasonable.

This can even involve actively shorting into the bid. For example, when the announcement was made in March 2003 that U.S. Airways' plan to emerge from bankruptcy was approved, the old common shares, which were trading on the OTCBB, rallied, even though the plan of reorganization called for canceling the old common shares. Apparently, some investors had not done their homework and had bought the shares on the mistaken notion that the old shares were going to be worth something again. Nevertheless, the old shares were destined to become worthless in a few days. By shorting the soon-to-be-worthless old stock into this speculative mini-bubble, the shorts could push down the price closer to where it should have been, zero. By doing so, they would have reduced investor losses because the investors would have paid a lower price for their foolish purchases. However, because of the difficulty that most retail investors face in shorting OTCBB stocks, only the market makers could have performed this vital role.

There are other times when markets work better because market makers can short easily. For example, from time to time fraudsters pump up microcap stocks, pushing their prices to unrealistic levels. In such instances, short sellers should make it harder for manipulators to push prices up, leading to more efficient prices in the market. This also reduces the incentive for microcap fraud, and presumably deters it. However, because it is hard for individuals to short OTC stocks, this job is left up to the market makers. This means that the market makers may have to sit on large short positions for long periods of time.

These legitimate anti-fraud activities can also result in fails to deliver. For example, the manipulators who are pumping up a stock may attempt a short squeeze by asking shareholders to demand delivery of the shares. A short who has legitimately borrowed the shares may have them recalled and be unable to locate the shares at a reasonable price.

It is easier to identify a bona fide market maker than bona fide market making trades.

As discussed above, it will be major compliance and enforcement headache to sift through millions of trades and try to figure out which ones are "bona fide market making" and which are not. Instead, the Commission should just exempt all legitimate market makers from the location requirements.

The "90-day freeze out" provision is a good idea.

The proposal to prohibit future shorting for 90 days from accounts that fail to deliver when there are large failures to deliver is generally a good idea. However, the wording is too broad. Some accounts may be failing to deliver through no fault of their own.

Some investors may be in a fail position because other investors have failed to them. For example, an investor buys stock at 10am and sells the stock at 2pm. However, the original seller fails to the investor, who then fails to deliver on the afternoon sale. The rules should not punish an investor who is in a fail position because another investor has failed to them.

The rule needs to clarify how failure lengths are measured.

For example, suppose that a high frequency trader fails for 1000 shares on day 1. The next day, the trader purchases 10,000 shares and sells 10,000 shares, once again ending the day failing to deliver by 1000 shares. Is this a new failure, or an old failure? Did the purchase of the first 1000 shares cover the original failure or not? Is the failure one day old or two days old?

Exceptions need to be made in fraudulent situations.

If the failure to deliver is a result of fraudulent activity on the part of manipulators, then the penalties need to be relaxed. There needs to be some kind of safety valve so that the delivery requirements can be relaxed in rare and exceptional circumstances. Perhaps the clearing agency could be empowered to stay the implementation of the rule if it believes that legal action could be pending.

The "90 day freeze out" may not deter real abusers.

Any genuine sleazoid who is frozen out by the rule could easily open another account, and then abuse that one until it is frozen, and then go on to another account. The Commission will need to monitor the situation to assure that the rule meets its aims.

Part III: The pilot program.

The pilot experiment is a great idea!

I strongly support the notion of a pilot. Rather than make major changes in a marketplace based on theory, ideology, or instinct, the pilot allows us to gather hard data for making good decisions.

The pilot should begin with the new bid test.

I have informally examined short selling restrictions in many different stock markets around the world, and I am unaware of any other stock market with a bid test exactly like the proposed rule.4 Given the ever present danger of unintended consequences, it seems prudent to start the pilot with the new bid test. This will give the industry the ability to test their systems more thoroughly, and to gather data on the efficacy of the new rule compared with the existing rules. The industry's experience with phasing in decimalization and SuperMontage indicates that accommodating the pilot should not be a major burden.

I envision the pilot as follows:

Phase I: Start with a small number (perhaps 10 NYSE, 10 AMEX, and 10 NASDAQ-listed stocks) of low volume stocks for 10 trading days to test systems.

Phase II: Implement the rule for a stratified sample of 300 NYSE and 300 NASDAQ and 100 AMEX stocks. This sample would include 30 stocks from each size decile in each market (but only10 for the AMEX because of its smaller size). Each chosen stock would have a matching stock matched on exchange, industry, market capitalization, price, and average trading volume. This phase would last for six months or a year. After three months, there would be a preliminary review to see if we should proceed to Phase III.

Phase III: Roll out new bid test to all covered stocks. This phase would last for six months or a year.

Phase IV: Experiment with dropping the bid test for a sample of stocks for one year. Although it is tempting to use the same sample as Phase II or the controls, corporate actions over time such as mergers and delistings make it reasonable to choose a new test sample and new controls.

The pilot must gather sufficient data to test the system.

In order to be an effective experiment, the pilot must gather sufficient data on the test stocks and their controls to test the new rule. After all the third stated objective is "(iii) preventing 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." In today's highly automated markets, the data will be available to test whether the new rules meet this third objective. The Commission just needs to make sure that the data are preserved and made available for study.

In particular, information about the state of limit order books on the NYSE, NASDAQ, Instinet, and Archipelago systems so that one can see how often short sale orders exhaust liquidity in their limit order books. This means that datasets should contain information about each order that arrives at each market. This information for each order received in the test securities and their controls should include:

  • Market center

  • Ticker symbol

  • Order number

  • Date and time of order arrival (to the millisecond)

  • Consolidated Best Bid or Offer at time of order arrival

  • Buy/sell/short/exempt

  • Market/limit

  • Limit price (if any)

  • Stop price (if any)

  • Time-in-force

  • Cancellation time(s) (to the millisecond)

  • Replacement order number (if cancel and replace)

  • Special handling codes (e.g. not held, work, etc., similar to the NASD OATS reporting codes)

  • Reserve amount (whether the order is to be displayed)

  • Quantity

  • Date(s) and time(s) of execution (to the millisecond)

  • Execution quantities

  • Execution price(s)

  • State of limit order book at the time order was received. (shares available at each price level up to 10 levels away from consolidated BBO.)

  • Account type (Individual, Agency, Proprietary, Program trading, similar to the codes currently maintained by the NYSE in its SOD files.)

  • Any other needed information

As the market centers involved already have this data in machine readable form, preserving it for the pilot stocks should not be a major burden.

Pilot data should be posted on the web to promote research by academics.

In order to make sure that we gather as much useful knowledge from the pilot as possible, it should be easy for as many researchers as possible to examine the data. This means that the data should be made widely available by posting it on the web, much as the 11ac1-5 data are posted.

Part IV: Additional disclosure is needed.

It is often difficult for investors in the United States to obtain good data on short selling. Although monthly short interest data are released by the NYSE and NASDAQ markets, this information comes out only once a month. Furthermore, this information is totally missing for the OTCBB and Pink Sheets markets. This data quality lags other countries, such as Australia, where short sales are disclosed immediately.

One problem is that short sellers often get blamed for sharp price declines even when they are not at fault. For example, large blockholders may be selling on inside information, and blaming the shorts for the resulting collapse in price. By publishing additional information about short selling, our market centers can dispel some of the myths about short selling. Increased transparency will give investors more confidence that the markets are not being manipulated.

Short interest data should be required for all stocks including the OTCBB and Pink Sheets.

At the very least, monthly short interest data for all covered securities should be disseminated monthly. This is not currently being done for the OTCBB and Pink Sheets markets. Manipulators often blame short selling for price declines when it is the manipulators' long selling that is really to blame.

Market centers should release daily short sales activity for each stock.

The monthly short interest data are very crude and do not give investors much information about when short sellers are active in a particular stock. Market centers should be required to disclose daily short sales data on a stock by stock basis. Of course, they should be able to charge for this data just as they do for their other data feeds.

Daily data on delivery failures should be readily available.

Increasing transparency in the settlement system will also help investors and regulator become aware of situations of abusive naked shorting. The clearing agencies should post daily to the web a list of covered securities with abnormally high delivery failures.


Proposed changes to rule:

Here is some sample language for suggested changes to the proposed rule:

§ 242.201

(a) ...

The term previous closing price shall be the price disseminated as the official closing price for the previous trading day by the primary listing market for the stock.

... The term bona fide market maker shall refer to any market maker

(1) who is registered as a market maker or a specialist in a stock on a national securities exchange or a national securities association and

(2) whose bid quotation or offer quotation matches the national best bid or offer at least 5% of the time for at least 75% of the covered securities in which market maker is registered as a market maker.

(b) All short sales of any covered security must be effected at a price at least the lower of either

(1) one cent tick above the current best bid displayed as part of the consolidated best bid and offer at the time of execution., or

(2) the previous closing price.

§ 242.203 Borrowing and delivery requirements


(2) The provisions of paragraph (b)(1) of this section shall not apply to short sales executed by bona fide specialists or market makers. in connection with bona-fide market making activities. Bona-fide market making activities shall not include 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.

1 Indeed, my hero, Professor Robert Schwartz often quotes a former president of the NYSE as stating "We produce the price." And, as the SEC well knows, this price information is extremely valuable.
2 Although automation, decimalization and the order handling rules rightly deserve most of the credit for the reductions in spreads over the last decade, improved risk management by trading firms has also played a key role.
3 As fans of securities law minutiae well know, Section 7 of the Securities Exchange Act gives the Board of Governors of the Federal Reserve Board, not the SEC, the authority to set margin requirements. This curiosity in regulation stems from the linkage between the banking system and margin lending. Reg T(§220.11) also sets other requirements, such as a minimum of four market makers, along with requirements on the number of shareholders, minimum capital and so forth. These restrictions appear to be aimed at protecting margin lenders from fraudulent or illiquid collateral that cannot be sold quickly. It is highly unlikely that these Reg T restrictions are useful in preventing systemic risk, due to the small size of the entire microcap sector.
4 One of the shortcomings in the concept release and the proposing release is that neither examined how other markets around the world deal with short selling. I recommend that the Commission make a regular habit of examining practices in other jurisdictions in future concept releases and rule proposals.