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Monday, 12/02/2013 12:48:11 PM

Monday, December 02, 2013 12:48:11 PM

Post# of 506
The OTC and Riskless Principle Transactions,

When a new shell was to be quoted on the OTCBB it had to file with the SEC and apply for certain services. Once the SEC approved of their filings an MM would file a Form 211 for quotation of the security and at the same time apply for DTCC eligibility. In the past the “sponsoring” MM would take on an inventory of stock that would act as the Float, no other MM could quote the security for 30 days, after that 30 day period they would apply for the “piggyback exception”. These MMs often maintained an inventory of the security for trading, as they created liquidity in the market.

The problem with the OTC however is that is in fact a very “illiquid” market, these securities often just rotted in the MM accounts removing valuable capital from their assets. On a given day there are over 10,000 securities quoted on the two tier OTC markets, of those less than 200 on average have actual consistent trading activity. Many of the sponsoring MMs have disappeared and in fact the number has been on steady decline since the big drop in 2008:



The DTCC was making a big push to create a fully electronic clearing and settlement process. This included electronic “deposit” services, this led to the DTCC assuming the “Float” as opposed to the sponsoring MM if the security gained DTC Eligibility. Over the years the DTCC has assumed all the risk involved in OTC securities for free trading securities. The OTC also moved completely under FINRA and their incorporation of NASDAQ Rules and part of that move was the use of Riskless Principle Transactions that began in 2001:

http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p003972.pdf

The industry slowly over time has progressed to not “owning” these OTC securities through two different changes in how the transaction is executed and Cleared and Settled. The MMs no longer primarily trade these securities on their own “principle account”, they simply use Riskless Principle to achieve a net 0 balance in these securities at the end of the trading day. It is simple process, you place your shares up for sale and your broker which is the first tier of the OTC tries to sell your security internally to another customer, if there are no buyers internally then the order is sent to the contracted MM at the second tier. The MM has overall “market view” and has far more options to execute your trade.

So let us say you have 1 million shares to sell at your “limit order”, and someone wants to buy 500,000 shares at your asking price. The contracted MM will sell 500,000 shares to that buyer in an “initial leg” of the trade transaction, these shares are marked “short” although despite the actual long position of the buyer and seller. SEC Rule 200 requires any trade that a party executes that does not physically own the shares in the transaction to be marked “short”, the MM not owning the shares will in fact mark the trade “short” and is reported to the CONSOLIDATED TAPE. The Consolidated Tape is what you see on L1 and L2.

Now on a separate leg of the same trade transaction the MM will buy your shares to cover the open position of 500,000 shares they sold on the initial leg. This transaction is reported in a NON TAPE TRANSACTION report to FINRA. This process all takes place in seconds and leaves no open position, yet due to SEC Rule 200 requirements the trade is reported to the Daily Reg SHO report as “short”. It doesn’t matter if the trade was already covered with shares before close, the SEC is not interested in delivery of actual shares. They simply want a record of how the trade was “initially” transacted as the FAILS TO DELIVER report will disclose after T+3 (Trade date plus 3 days for settlement) if there are any open positions caused by no shares being delivered.

Under the former marking requirements in Rule 10a-1(d), a broker-dealer could only mark an order to sell a security "long" if the security was carried in the account for which the sale is to be effected, or the broker-dealer is informed that the seller owns the security to be sold, and will deliver the security to the account for which the sale is effected as soon as possible without undue inconvenience or expense.35 We had proposed changing the marking requirement so that a sale could only be marked "long" if the seller owns the security being sold and either the security to be delivered is in the physical possession or control of the broker-dealer, or will be in the physical possession or control of the broker-dealer prior to settlement of the transaction.



There are many reasons for FTD’s, and they are a common occurrence and the SEC makes it clear that they do not occur for a specific reason and are in fact not proof of shorting or abusive naked short selling.

Please note that fails-to-deliver can occur for a number of reasons on both long and short sales. Therefore, fails-to-deliver are not necessarily the result of short selling, and are not evidence of abusive short selling or “naked” short selling. For more information on short selling and fails-to-deliver, see http://www.sec.gov/spotlight/keyregshoissues.htm, http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm, and http://www.sec.gov/rules/final/34-50103.htm.



As far as where do the MMs make their money, well in Riskless Principle it is simply an agreed upon percentage with your broker for each transaction, that is part of your fees paid for each trade. They also make money on Arbitrage, one of the few instances of trading on their own “principle” account. A common trade that results in an opportunity to make money on the Spread is the “market orders” placed by those trying to get out quickly or amateur traders who do not know better. The MM algorithm seeks such opportunities of arbitrage by purchasing the market order at Bid and selling at or below the Ask. As we all know the spread in the OTC can be pretty large in some cases.

Deposit of newly issued shares is probably the largest money making opportunity, the customer pays a pretty hefty deposit fee of 10-15%. As the MM sells this “block position”, they sell shares to the market all day long and then buy from the block with an “averaged weighted transaction” less commission costs. They charge typically 1.5% per transaction on each weighted trade, so they in effect create a “spread” in this case, average Market price minus the commission. A good example are trades at say .10 all day long and averaged at .10 then subtracting the commission of 1.5% results in one single large trade of the combined volume for .085.

Are the other cases of trading on their own “principle”? Yes, there are instances in which volume is so heavy that transactions from multiple MMs may in fact leave an MM in an open position because the shares they initially transacted were sold by another MM before buying the cover. This means now the MM must buy from the market to cover that transaction, some of these are settled within seconds while other may be days before they cover. Also remember that some trades may in fact be “partial” transactions, the same occurrence as your own trade being sold in pieces.

FINRA has petitioned the SEC in regards to the Daily Reg SHO reports, due to the data not showing a true “short” position or open position at the end of the trading day due to Riskless Principle transactions. FINRA would like to either eliminate the reporting of such Riskless Principle transactions or provide a separate column for such transactions in order to provide an accurate report that could be used in a meaningful manner.

http://www.sec.gov/comments/sr-finra-2009-064/finra2009064-1.pdf


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