One Step Ahead

[Euthydemus]

Bo - I assume as a condition of any rational discussion of market issues that the participants understand how the markets actually work. Your post leaves a considerable doubt in my mind of that in the present case.

Do you actually believe that when you put in an order to buy 100 shares of XYZ that your broker goes to a market maker and buys from him ONLY if he has shares of XYZ or...or what BO? Have you ever had a broker call you back and say "Sorry, we're all out of XYZ today, call back tomorrow". No, you haven't. You know why? Because the market maker as part of his role in providing virtually instantaneous liquidity sells the 100 shares marked "long" and moves on whether he has them in inventory or not. And if, by chance, XYZ is in high demand he may sell thousands of shares that way, every single one "naked" by the technical definition of a "naked short" - except they weren't sold short, they were sold long and will settle within T+3 through the DSCC/NSCC settlement services.

And, of course, nobody seems to mind when selling time roles around. Then the market makers MUST buy our shares of XYX in unlimited quantities no matter what his inventory level is...when a lot of that goes on, the price falls. At the end of one of those days, the market makers will be left holding a bunch of shares of XYZ. And if the price falls again tomorrow? Tough, that's just the way the cookie crumbles.

The net effect over time of all the market makers buying and selling should net to zero. The exceptions are what Reg SHO was designed to address. Time will tell whether those issues are being addressed. I won't even get into the market consequences of legitimate short sales - it is not applicable to the present discussion.

Your suggestion that the long sales activity described above will cause the price of XYZ to fall is completely contrary to experience (I'll bet yours and certainly mine). It is a myth that market makers only sell a stock they have in inventory - I've known that for over 20 years. The higher the demand, the more likely the shares sold will be sold "naked" and again, under those conditions, the price will rise.

I have included a couple of sections from the SEC ruling on REG SHO regarding "Bona-fide Market Making" and a link to Rule 203 which makes the exemption.

I just read your Part 2 - IMO, it lends nothing further to the discussion.

b. Bona-fide Market Making

We are adopting the proposed exception from the uniform "locate" requirement, as Rule 203(b)(2)(iii), for short sales executed by market makers, as defined in Section 3(a)(38) of the Exchange Act,[66] including specialists and options market makers, but only in connection with bona-fide market making activities.[67] Bona-fide market making does not include activity that is related to speculative selling strategies or investment purposes of the broker-dealer and is disproportionate to the usual market making patterns or practices of the broker-dealer in that security. In addition, where a market maker posts continually at or near the best offer, but does not also post at or near the best bid, the market maker's activities would not generally qualify as bona-fide market making for purposes of the exception.[68] Further, bona-fide market making does not include transactions whereby a market maker enters into an arrangement with another broker-dealer or customer in an attempt to use the market maker's exception for the purpose of avoiding compliance with Rule 203(b)(1) by the other broker-dealer or customer.[69]

[66] Section 3(a)(38) states: "The term `market maker' means any specialist permitted to act as a dealer, any dealer acting in the capacity of a block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an inter-dealer quotation system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis." 15 U.S.C. 78c(a)(38).

[67] As noted in the Proposing Release, we believe that a narrow exception for market makers engaged in bona-fide market making activities is necessary because they may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the "locate" requirement.

[68] Moreover, a market maker that continually executed short sales away from its posted quotes would generally be unable to rely on the bona-fide market making exception.

[69] See also NASD IM-3350(c)(2) ("A market maker would be deemed in violation of the Rule if it entered into an arrangement with a member or a customer whereby it used its exemption from the rule to sell short at the bid at successively lower prices, accumulating a short position, and subsequently offsetting those sales through a transaction at a prearranged price, for the purpose of avoiding compliance with the Rule, and with the understanding that the market maker would be guaranteed by the member or customer against losses on the trades."). Although the IM-3350 interpretation applies expressly to the bid test in NASD Rule 3350, the NASD previously found that the standards set forth are equally applicable to the market maker exemption in NASD Rule 3370. See NASD Hearing Panel Decision as to Respondents John Fiero and Fiero Brothers, Inc. (December 6, 2000); See also Section 20(b) of the Exchange Act, 15 U.S.C. 78t.

http://www.sec.gov/rules/final/34-50103.htm#P188_60191

Short sales effected by a market maker in connection with bona-fide market making activities in the security for which this exception is claimed;

http://www.law.uc.edu/CCL/regSHO/rule203.html