September 18, 2008
To The SEC Commissioner, The Hon. Christopher Cox
The theory behind allowing sellers to sell stock they don't own is that it balances the effects of being able to buy stock (on margin) with money you don't have, and is therefore market neutral. I will come back to that, as the current regulations have gotten skewed and are not market neutral, but have a 40% bias to the downside.
Take as an example a normal stock with a 30% margin requirement. That means you can buy 30 shares with cash plus 70 shares with borrowed money, making 100 in total. Being allowed to do that has potentially increased the demand in the market by 70 shares, compared to the only 30 you would have been able to buy otherwise.
Now, short sellers must borrow stock before they can sell it, and the current regulations say that the only place from which they can borrow stock is a margin account in debit, i.e. one that has bought more shares than it had cash to pay for. Thus the 70 shares bought with borrowed money in the above example are made available for short sellers to borrow, and therefore contribute 70 shares to the supply-side, balancing the demand-side effects of being allowed to buy on margin.
At this point we can determine that there is a flaw in current regulations, which do not restict borrowing to only the 70 shares bought on margin, but allow the broker to lend nearly all 100 shares out of the margin account to short sellers, thus creating a 1.4:1 skew in favor of short sellers. The flawed regulation in question is Federal Regulation 240.15c3-3, entitled "Customer protection-reserves and custody of securities", wherein paragraph(a) subpara (5) reads:
(5) The term excess margin securities shall mean those securities referred to in paragraph (a)(4) of this section carried for the account of a customer having a market value in excess of 140 percent of the total of the debit balances in the customer's account or accounts encompassed by paragraph (a)(4) of this section which the broker or dealer identifies as not constituting margin securities.
This paragraph defines excess margin securities , which are those that may not be lent to short sellers, as those having a market value in excess of 140% of margin debit balances. Thus those that may be lent are those up to a market value of 140% of margin debit. In the above example of 70 shares bought with borrowed money, 140% of that 70, or 98 shares, may be lent to short sellers. This creates an extra supply of 98 shares, which exceeds by 40% the extra demand of 70 shares created by margin buying.
Even worse: The regulation is silent on what may be done in the case of the account containing several different securites. The brokers are allowed to interpret the regulation as meaning ALL of the margin debit may be applied to any share they choose in determining how many shares they can lend, even if that share is only collateralizing a tiny fraction of the margin debit, and even if that share is not allowed to be bought with margin borrowings at all, e.g. a share deemed to be of high volatility that has a 100% margin requirement. This creates a highly destabilizing influence on certain securities, as we have just seen over the period 2006-2008 , because it allows short sales of those securities without allowing corresponding purchases using margin borrowings to balance the effects.
Regulation 15c3-3 should be amended with all speed to stop short selling abuse and level the playing field.
Paul W. Dent