Subject: File No. S7-19-07
From: Dave Patch

January 23, 2008

This says it all...

The reality is that all the people using the exemption arent necessarily traditional market makers, said an analyst at a hedge fund that used to have status as an options market maker and still trades options. Its relatively easy to become a market maker, or short sellers can simply place orders through market makers.

Naked And Ashamed? Rule Change Could Curb Shorting Practice

DowJones Hedge Fund Trades

The controversial practice of selling stock in a company without owning it, known as naked short selling, could be curbed by a change in securities regulations now under discussion.

The Securities and Exchange Commission is still unofficially accepting comments on a proposed amendment to Regulation SHO, the rule that regulates short selling, which would remove the options market maker exemption from the rule. An SEC spokesman said a final decision on the amendment is expected in the first half of 2008. The exemption allows options market makers on U.S. options exchanges to sell stock they dont own at the same time they short positions by selling put options, which confer the right to sell a stock at a predetermined price.

Other traders engaging in short sales of stock must deliver the shares within 13 days, but options market makers are exempt from that rule, an exception intended to maintain liquidity at the exchanges. A spokeswoman at one of the exchanges, speaking anonymously, cited the need for the exemption, saying that an options market maker has to be able to make instantaneous, two-sided trades.

However, critics say the exemption is being used as a backdoor route to naked shorting, which is illegal. A lifting of the exemption could support the stocks of companies such as Novastar Financial and Inc., which have for a long period been on the list of stocks with 13-plus day failures to deliver against short positions.

The reality is that all the people using the exemption arent necessarily traditional market makers, said an analyst at a hedge fund that used to have status as an options market maker and still trades options. Its relatively easy to become a market maker, or short sellers can simply place orders through market makers. The hedge fund analyst said that removing the exemption would potentially make it harder for hedge funds to use options to short hard-to-borrow securities. Thats because the options market makers wouldnt be able to process the trades on those options, because the short positions are so high that its impossible to physically locate shares.

Among such stocks with high short interest are beleaguered mortgage lender Novastar Financial, which is now trading at less than $2 a share and has moved to the pink sheets after announcing last week its cutting 85% of its workforce and letting its mortgage licenses lapse.

Novastars stock was one of 156 analyzed by Vodia Group LLC, a Concord, Mass.-based consulting firm for the financial services and financial technology industries. Vodia looked at all of the stocks with negative rebate rates those in such demand by short sellers that the interest rate paid by a bank for the stock becomes negative and the hedge fund in turn pays the bank the interest and have options trading against them.

Yes, removing the options market maker exemption will remove downward stock pressure that has existed to provide liquidity to markets, said Joshua Galper, managing principal of Vodia. His research is based on an analysis of options data and verification with market makers of his profitability assumptions. It found that if the exemption is repealed, there would be a net reduction in equity and index option contracts of 2.5%, and a reduction of 87.7% for options with hard-to-borrow securities.

For those hard-to-borrow stocks, Galper said, there is no way options market makers would still be able to capture the high spreads of borrowing costs over the prices of the stocks they currently receive if the exemption is lifted and theyre forced to locate shares. Thats because the inability to locate the shares would stop them from trading the options altogether.

Other stocks on the list include Internet retailer Inc., which has been on the naked short list for more than 700 days and has a chief executive, Patrick Byrne, who has been railing for years against what he calls downward pressure in his companys stock and options by short-selling hedge funds. In a meeting with Hedge Fund Trades in New York last week, Byrne said his focus is not just on Overstocks stock but on naked short selling and the options market maker exemption in general.

John Welborn, an economist for Utah-based investment firm Haverford Group, which has worked with

Overstock to try and prove the manipulation in the companys stock and options, said removal of the exemption would certainly help with some of the naked short selling.

The options market makers and exchanges themselves want the exemption to stay, for obvious reasons. Arguing against the change in a Sept. 19, comment letter, option trading exchanges including the CBOE, Boston Options Exchange and Philadelphia Stock Exchange said the removal of the exemption could significantly harm the ability of options market makers to provide liquidity and narrow quote widths for options when the underlying security is a threshold security. A threshold security is defined by Regulation SHO as a security with an aggregate fail-to-deliver position for five consecutive settlement days at a registered clearing agency of 10,000 shares or more, and is equal to at least 0.5% of the issues total shares outstanding. It is those threshold securities, which short sellers find hard to locate, on which options market makers make the most money on because those options are in such high demand.

I was tremendously hopeful that things would really change, Welborn said, adding that hes no longer so sure how much things might change. Welborn pointed to the fact that much options trading is now done over the counter and is thus unregulated. Its just another case, he said, of sophisticated investors finding a way to circumvent the system. In other words, hedge funds will still figure out a way to participate in naked short selling. Im not convinced this means activity will be eliminated altogether, he said.