December 23, 2003
Mr. Jonathan G. Katz
I am writing to comment on the Securities and Exchange Commission's proposal to replace SEC Rules 3b-3, 10a-1, and 10a-2 with the ill-conceived Regulation SHO, under the Securities Exchange Act of 1934, as outlined in Release No. 34-48709; File No. S7-23-03. It is my opinion that Regulation SHO would not achieve the SEC's three main objectives of short sale regulation (see below). In addition, the objectives themselves contradict the SEC's stated requirement of an efficient market.
In Release No. 34-48709; File No. S7-23-03, the SEC has explicitly stated three main objectives of short sale regulation (section I.A.):
a) allowing relatively unrestricted short selling in an advancing market;
b) preventing short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down; and
c) 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 section I.B., the SEC also states that "efficient markets require that prices fully reflect all buy and sell interest... short selling provides the market with at least two important benefits: market liquidity and pricing efficiency."
The proposed bid test under Regulation SHO fails to accomplish the first objective of short sale regulation - the allowance of relatively unrestricted short selling in an advancing market. The bid test would do exactly the opposite - it would severely restrict short selling in an advancing market. There are two ways in which a buyer can buy stock - his bid can get "hit" by a seller or he can buy the offer (thus paying the spread). Conversely, there are two ways a seller can sell stock - his offer can get "taken" by a buyer or he can "hit" the bid (and pay the spread). Buyers have two methods of buying and sellers have two methods of selling. The bid test stipulates that regardless of whether the market is advancing or declining, a short seller can only get short one penny above the inside bid - this means that he cannot "hit" the bid, but rather must put up an offer one penny above the current bid and hope to get taken by a buyer, who is now forced to pay the spread to buy stock.. This greatly reduces the chances of a short sale getting executed. The bid test would eliminate one method by which short sellers can sell and would essentially invalidate the other method - resulting in very restricted short selling in any market.
Short sale regulation itself severely restricts both buy and sell interest, reduces market liquidity, and therefore creates pricing inefficiency. For example, if a buyer wishes to buy stock at the current inside bid, he is indicating a buy interest at that price. If there is a sell interest at the same price, then in an efficient marketplace, a transaction should occur. It is irrelevant to the buyer whether the sell interest comes from a short seller or a long seller - the buyer simply wants to purchase stock at that price. It would also be irrelevant to a seller on the inside offer whether that offer is taken by a buy interest or a short coverer - yet it would seem absurd to force buyers to buy stock either in a declining market, a down tick, or one penny below the inside offer. Assuming that the stock is declining, current short sale regulation prevents not only short interests from getting executed, but long interests from getting executed on the bid. Preventing a buyer and a seller from transacting at an explicitly agreed price reduces liquidity and does not accurately reflect prices at which buyers wish to buy and sellers wish to sell. Therefore, the second and third objectives of short sale regulation directly contradict the SEC's own requirements of an efficient market.
It is understandable that the SEC is concerned with "illegal stock manipulation" through short selling. The example cited in Section I.A. refers to the concept of a "bear raid," in which short sellers attempt to drive the stock down in an effort to create an imbalance of sell side interest. What the SEC fails to see is that this type of manipulation is primarily a problem with specialists, not short sellers. For example, it is common practice among specialists to drive their stock down temporarily (particularly in an advancing market), only to execute the limit and market sell orders generated by this sudden downward movement from their own book. Frequently, they deny the current inside bid from getting executed by "front-running" - buying in front of the bid, "soaking" up stock from sellers. Specialists also do the opposite in a declining market, artificially pushing their stock up, only to front-run the inside offer and getting short. Just as regulation against this "bull raid" would be ludicrous, so should short sale regulation. Instead, there should be tighter controls laid upon the specialists themselves, as they are the ones most likely to profit from these so-called "bear raids."
As a professional trader and registered representative, I can attest to the effects of Regulation SHO and short sale regulation on the liquidity and price efficiency of the secondary market. I sincerely hope that the Securities and Exchange Commission will see the contradiction between over-regulation and providing an efficient marketplace.