Knight Capital Worried about Reg Sho Changes
Nancy M. Morris
Secretary
Securities and Exchange Commission
100 F. Street, NE
Washington, DC 20549-9303
Re: Release No. 34-54154; File Number S7-12-06
Proposed Amendments to Regulation SHO
Dear Ms. Morris:
Knight Capital Group, Inc. ("Knight")[1] welcomes the opportunity to
offer our comments to the Securities and Exchange Commission
("Commission") on the proposed amendments to Regulation SHO.[2] The
proposed amendments seek to: (i) eliminate the grandfather provision
for fails; (ii) modify the options market maker exemption for closing
out fails; and (iii) address the unwinding index arbitrage positions.
The Commission also requests comment on a number of additional
questions. Since our business will be impacted directly by the
proposal relating to the elimination of the grandfather provision, we
will focus most of our comments on that issue.
Proposed elimination of the grandfather provision
The Commission proposes to eliminate the grandfather clause of Rule
203(b)(3)(i). This rule generally exempts fails to deliver that
existed prior to the security becoming a threshold security. The new
amendment would require that all grandfathered fails be closed-out
within 35 settlement days from the effective date of the amendment
and if a security becomes a threshold security after the effective
date, all fails would need to be closed out within 13 consecutive
settlement days. We respectfully oppose such a change.
We believe that the empirical data now available shows that this
proposal is not necessary – see, Memorandum from the Commission's
Office of Economic Analysis (August 21, 2006). For example, "99.2% of
the fails that existed on January 3, 2005 are no longer outstanding
as of March 31, 2006" (Memorandum at page 2).
Additionally, the elimination of the grandfather provision will lead
to increased volatility in these securities, created by short
squeezes as individuals attempt to cover positions. Importantly, the
elimination of the grandfather provision will negatively impact bona
fide market making and the ability of market makers to provide
liquidity. As the Division of Market Regulation correctly noted,
There may be legitimate reasons for a failure to deliver….For
example, market makers who sell short thinly traded, illiquid stock
in response to customer demand may encounter difficulty in obtaining
securities when the time for delivery arrives.
Naked short selling is not necessarily a violation of the federal
securities laws or the Commission's rules. Indeed, in certain
circumstances, naked short selling contributes to market liquidity.
For example, broker-dealers that make a market in a security
generally stand ready to buy and sell the security on a regular and
continuous basis at a publicly quoted price, even when there are no
other buyers or sellers. Thus, market makers must sell a security to
a buyer even when there are temporary shortages of that security
available in the market. This may occur, for example, if there is a
sudden surge in buying interest in that security, or if few investors
are selling the security at that time. Because it may take a market
maker considerable time to purchase or arrange to borrow the
security, a market maker engaged in bona fide market making,
particularly in a fast-moving market, may need to sell the security
short without having arranged to borrow shares. This is especially
true for market makers in thinly traded, illiquid stocks such as
securities quoted on the OTC Bulletin Board, as there may be few
shares available to purchase or borrow at a given time. (emphasis
supplied and citations omitted)
See, Division of Market Regulation: Key Points About Regulation SHO
(April 11, 2005).
Thus, to restrict – indeed eliminate, the ability of market makers to
satisfy these investor needs will undoubtedly lead to less liquidity,
greater volatility, and widening of spreads. Further, in certain
instances, restricting bona fide market making in such a fashion
could lead to upward price manipulation (i.e., the return of "pump &
dump" schemes) causing investors to purchase shares at inflated
prices.
If the Commission does determine, however, to move forward with the
elimination of the grandfather clause, we urge the Commission to
adopt a permanent phase-in period of 35 days for all fails to deliver
incurred in securities prior to those securities becoming a threshold
security. In addition to the reasons stated above, Knight is very
concerned that the elimination of the grandfather provision will
necessarily inject a new risk dynamic into the market making process
that is nearly impossible to predict and even more difficult to
measure. More specifically, when making a decision whether to sell
short to an investor seeking to buy a "non-threshold" stock, a market
maker today can adequately assess the risk associated with providing
liquidity and capital to that order. Although there is always a risk
of price movement, a market maker can manage that risk by deciding
when to buy back that position. Under the current proposal, the
market maker loses that risk management capability. Thus, if the
stock is not a threshold security the day the market maker sells
short to an investor, but becomes a threshold security shortly
thereafter, the risk incurred by the market maker on the day it went
short will exponentially increase – since, the market maker can no
longer manage its exit point on the position and will now be forced
to close that position within 13 consecutive settlement days. In
effect, a new and substantial risk will be applied retroactively to a
market making decision made in the past. So, through no fault of its
own, the market maker is now forced into a potentially precarious –
and costly, position.
Consequently, in light of the additional and substantial new risks
the market maker is being asked to bear, and since this risk will be
incurred in connection with activities designed to serve the
investing public (i.e., bona fide market making), we suggest an
extended, permanent buy-in period of 35 settlement days in these
situations. No harm will come to any investor or the marketplace with
this modest extension of time, however it will help market makers
somewhat manage this newly created risk.
Additional questions posed by the Commission
The Commission raised additional questions in the proposed amendments
which we would also like to address:
1. Should there be, "a mandatory pre-borrow requirement in lieu of a
locate requirement for threshold securities with extended fails?"
If the Commission was to adopt a mandatory pre-borrow requirement in
lieu of a locate requirement for threshold securities with extended
fails to deliver, we submit that the Commission should clarify that
such requirement would not be imposed on transactions that are
exempted from Rule 203(b)(1) by Rule 203(b)(2). If such transactions
are not exempted from the pre-borrow requirement, it could impact a
market maker even if it did not have an extended fail. Such a
requirement could also provide an un-level playing field to certain
market participants. Specifically, broker/dealers that have extensive
stock loan businesses will have the advantage of transacting in
securities at costs much lower than other firms. Overall costs to
other broker/dealers would increase as they would have to use capital
and pay higher borrow costs to make a market in the stock even though
they are not contributing to the fail. In addition, a market maker
would be required to incur these borrow costs if it wanted to post
quotations if such quotations may result in the market maker selling
stock short. This will impact negatively a market maker's ability to
make markets in threshold securities – thereby reducing liquidity for
threshold securities.
2. Should the, "current close-out requirement of 13 consecutive
settlement days for Rule 144 restricted threshold securities or other
types of threshold securities should be extended?"
Knight supports extending the close-out requirement from 13
consecutive settlement days to at least 35 settlement days for sales
in threshold securities related to sales effected pursuant to SEC
Rule 144, or other similar situations where delays may occur in
settlement. Requiring a close-out of "owned" shares in the 13-day
period has resulted in serious consequences to sellers that "own" a
security who, through no fault of the seller, were not able to settle
the transaction by the 13th day. For example, the mechanics of having
the transfer agent remove a restrictive legend often results in
delays of settling transaction beyond 13 settlement days. [3] These
delays are not a result of the abusive short selling practices that
Regulation SHO was intended to address. Instead, they are typically a
result of ensuring that proper documentation is received to remove
the legend (e.g., an opinion of counsel).
In addition, transactions in restricted securities are typically
larger in size and occur over several days or weeks which increases
the risk that such transactions will be subject to a buy-in because:
(i) the fails associated with the sales of restricted shares may be
sufficient enough to cause the security to become a threshold
security or delay a security from being removed from the threshold
list; [4] and (ii) sellers are typically not permitted to start the
process of removing the restrictive legend until after the shares are
sold. Moreover, using the last-in-first-out ("LIFO") method of
closing out fails-to-deliver, the seller of restricted securities is
subject to a greater risk of buy-in because shares that are delivered
to settle one trade may be applied to a subsequent trade that is also
causing a fail-to-deliver.[5]
3. Should the Commission except "ETFs or other types of structured
products from the definition of threshold securities?"
We support such a proposal and submit that such an exception should
extend to other structured products and American Depository Receipts
(ADRs). These types of securities are not subject to the potential
short selling abuses as there value is derived from an underlying
basket of securities or underlying foreign security. In addition,
ETFs and ADRs are in continuous distributions making it difficult to
determine the correct outstanding shares for such securities. Thus,
the securities may become threshold securities when the fails-to-
deliver do not amount to 0.5% of the true outstanding shares.
4. Should the Commission, "consider tightening the locate
requirements?"
The Commission asks whether it should require that brokers/dealers
obtain locates only from sources that will decrement shares. We
respectfully oppose this proposal, as it will negatively impact the
ability of a broker/dealer to borrow stock. Since the vast majority
of locates do not result in an actual borrow by settlement, requiring
a decrement base simply on a locate request would have the effect of
reducing substantially the available stock for lending – thus,
increasing the cost to borrow the shares and overall clearing costs
(which, ultimately, may be passed on to the investor). Further, we
also believe that a great deal of time and money will need to be
spent by the clearing industry in developing systems and procedures
designed to accurately count and decrement shares each time a locate
is requested, cancelled, etc. In our view, the stock lending market
is not based on the ability to deliver all shares for which there is
a locate requested – rather, it is based on the ability to deliver
stock in those instances where a broker/dealer is required to borrow
the stock to settle a short sale. Since most locates do not result in
a need to borrow shares to settle trades, there is no compelling
reason to tie-up all stock available for lending.
5. Should the Commission require the, "dissemination of aggregate
fails data or fails data by individual security?"
We respectfully disagree with this proposal. Such disclosure would
cause more confusion as the information is not indicative of abusive
short selling, especially in light of fails caused by "owned"
securities (restricted sales). Thus, for example, investors may
mistakenly believe that a large percentage of fails to deliver is
indicative of abusive short selling or problems with the issuer, when
it could be a result of an operational delay with a transfer agent or
a delay in removing the legend for a restricted securities
transaction. This mistaken belief could result in increased
volatility in the stock and increased short selling.
If the Commission were to require aggregate fail data to be
published, Knight believes that such information should be limited to
aggregate street-wide fails by cusip number, and that SROs should
publish the data they receive from the National Securities Clearing
Corporation ("NSCC"). In addition, the data should only be published
for securities that are on the threshold list for 35 consecutive
settlement days to avoid situations where the security became a
threshold security as a result of restricted securities transactions
or operational delays.
6. Should the Commission require, "additional specific documentation
of long sales?"
We would oppose such a new requirement. We are not aware of any data
which suggests there is a problem in this area. Most broker/dealers
have fairly extensive compliance and supervisory requirements
designed to confirm sales are properly marked "long" or "short" and
to monitor settlement of transactions by its clients. This new
proposal will add substantial costs to an already robust
infrastructure, with minimal benefit. However, if the Commission does
seek to amend Regulation SHO to require increased documentation for
long sales, Knight submits that an executing broker should be exempt
from such requirements when there is: (i) a prime brokerage
relationship; (ii) the trade is a DVP trade; (iii) settlement
instructions are on file with the executing broker; or, (iv) the
order is sent electronically.
Conclusion
We commend the continued efforts of the Commission to make
improvements to Regulation SHO and the marketplace. Knight would
welcome the opportunity to discuss our comments with the Commission.
Respectfully submitted,
AI
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