December 26, 2003
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Dear Mr. Katz:
I write to you to comment on the proposed changes to the Securities Exchange Act of 1934. My name is Yusef Burgess and I am a registered representative with the Trillium Trading Group. After reading through Regulation SHO, I find that many of the proposals unwillingly undermine the small investor. As a small investor, the replacement of rules 3b-3, 10a-1 and 10a-2 will have a substantial impact on my professional trading career.
The SEC proposed regulation seeks to institute a uniform bid test allowing short sales to be effected at a price one cent above the best consolidated bid. This proposed change would in effect create an imbalance within the market. The market's liquidity is composed of both longs and shorts. However, by allowing short selling to become more complex, you unwilling give a distinct advantage to the long buyers.
Short selling on a green arrow has been the cornerstone of the NASDAQ National Market since its adoption in 1994 on a temporary basis. The effect of the new proposal does not add any value to small investors. In fact, Regulation SHO put the small investor at a disadvantage by making it more difficult at getting short and creating liquidity. In spite of the fact that NASD Rule 3350 exempts Market Makers who "offset imbalances in the supply and demand of stocks or gaps in the flow of buy and sell orders", this appears ripe for abuse which could be prevented by not going forward with the changes as proposed.
On a day to day basis, market makers have the ability to manipulate stocks by not having to adhere to the same rules of shorting as the small investor. Market Makers argue that if they were required to wait for an up-bid to make a short sale, their ability to satisfy market making functions would be impaired. However, the majority of functions performed by Market Makers is done by computers that use electronic communication networks (ECN's) which can be programmed to adhere to the up-bid rule. This is also true for the small investor. However, the proposed changes only serve to further disadvantage the small investor in an environment where the market maker already has a clear advantage.
Market Makers further argue that they provide stability by standing ready to buy stock if there is heavy selling pressure by investors and the market is moving down. However, this argument is quickly weakened by the events on December 4, 2003, when COCO, a NASDAQ stock dropped $10 very quickly. It was later established that a trading error had occurred. However, during the time the stock was coming off hard I did not see one market maker "provide stability". Additionally, Market Makers assert that "the application of the short sale rule could increase market makers' costs, which would be passed on to investors in the form of wider spreads". However, one can quickly counter this assertion based on the fact that the largest market makers like Goldman Sacs and Merrill Lynch own the two largest ECN's (REDI & BRUT). Regarding the issue of "wider spreads", the SEC has already reduced the spreads to a penny, which moots the argument by the Market Makers.
The "locate rule", proposed in the Regulation SHO serves to protect the small investor. The idea of requiring short sellers in all securities to locate securities to borrow before short selling is both fair and equitable. Moreover, this proposal will eliminate the "failure to deliver" or "death spirals" schemes which seek to defraud investors.
The final proposed change which seeks to create a pilot program to study the effects of short selling on market volatility, priced efficiency and liquidity will be beneficial to the entire market. This prediction is evidenced by the current futures market. The act of eliminating the short selling rule in this pilot program would be more helpful, because it would closely resemble the futures market where short selling rules do not exist. The effect of the pilot program will offer the SEC a perspicuous view of how the market could handle the possible removal of the short selling rule.
As a small investor, I can only hope that the SEC will seriously consider my issues and concerns by revisiting the "Regulation SHO", and not adopting the regulation as currently proposed.
Yusef J. Burgess