Post by jannikki on Jan 19, 2007 22:13:48 GMT -4
STOCKGATE TODAY
An online newspaper reporting the issues of Securities Fraud
This SHO’s a Bust… - January 18, 2007
David Patch
Rarely is there ever a debate that rages on for such length in time where few facts are ever discussed and where perception is the only measuring stick used by the experts to evaluate progress.
Regulation SHO was drafted and proposed in late 2003 to address present day loopholes in a 70 year old set of laws. Abuses in short selling have increased over the decades as liquidity increased and the regulators were concerned that these failures due to the abusive short selling could be used as leverage to manipulate down the price of securities.
The regulators released Regulation into law in 2004 with an affectivity date of January 2005. The final release was theoretically designed to reduce the settlement failures in the system while in doing so prevent the market volatilities associated with “short squeezes”.
Theoretically!
The battle rages between investors [individuals and issuers] and the industry [regulators, Wall Street members, financial press] over the ultimate success of the 2-year-old law. Most of this battle rages without evidence to support the positions as transparency of data has been lacking.
Biased as I may be to this issue, enough data does exist that implies that the industry is either deceiving the public or has blinders on to the realities of Regulation SHO and success.
Let’s start with a few simple facts.
Industry Position: Regulation SHO was intended to reduce the level of settlement failures in the system. SHO has done that and requires no future changes.
Fact: Information obtained under the Freedom of Information Act provided evidence that the average daily level of fails and the number of companies qualified for the SHO threshold security list has not changed over the first 17 months of the program. This implies SHO has not met the intent of the Commission.
Industry Position: Regulation SHO has policies in place that force short sellers to cover fails after a period of 13 days of consecutive fails if that company is on the threshold security list.
Rule 203 (b)(3) States: If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security for thirteen consecutive settlement days, the participant shall immediately thereafter close out the fail to deliver position by purchasing securities of like kind and quantity.
Fact: Regulation SHO simply adds tighter shorting restrictions on member firms and their clients as the requirement of “immediately thereafter closeout” was left undefined in terms of immediately. By stating “of like kind and quantity” regulators are allowing Wall Street to apply cost into the factor.
For example, if a fail on a security sold took place with 10,000 shares at $5.00/share, and the present market is $5.50, those shares are not considered of like kind to that sold into a failure. The SEC rule does not require that the $5.50 shares be purchased to close out the $5.00 fails because of the allowed perception that they are no longer of similar kind.
In fact the SEC added a restraint to future short sales by drafting language into Rule 203 (b) stating…
The participant “may not accept a short sale order in the threshold security from another person, or effect a short sale in the threshold security for its own account, without borrowing the security or entering into a bona-fide arrangement to borrow the security, until the participant closes out the fail to deliver position by purchasing securities of like kind and quantity”
But in theory, if the closeout were mandatory and “immediate” there would be no need for this additional stipulation yet it exists. Instead of reliance on members to meet the “immediate” timeframe as we all understand the definition of immediate; the SEC put language into law that allows for Broker Dealers to execute additional short sales while past ones remain on the books as failed. The additional short sales can be used to potentially drive the market back to that theoretical $5.00/share threshold where the closeout could be made without a loss.
Industry Position: Eliminating the grandfather clause of Regulation SHO will unduly cause short squeezes. The grandfather clause referring to those fails that took place prior to a security being listed on the threshold security list and thus not required to meet the “immediate close out” provisions of Rule 203 (b) (1). According to a memo from the SEC’s Division of Market Regulation, “Regulation SHO does not require the close-out of fails to deliver that existed before a stock became a threshold security (known as "grandfathered" securities) because the Commission was concerned about creating volatility through short squeezes if existing positions had to be closed out quickly. “
Fact: Short squeezes are only created when mandatory buy-ins take place, in large quantity, and at any offered market price. In this case, the fears of a short squeeze being are those events where a massive quantity of failed trades are suddenly forced to be settle, but only those now booked as grandfathered fails.
Utilizing data obtained under the Freedom of Information Act, Overstock.com had roughly 280,000 Fails in the system on the day they were first listed on the threshold security list in January 2005. By March 17, 2006 this number had accumulated to 3.6 Million shares. This is an increase of 1185% while theoretically trading under mandatory and immediate closeout provisions of Rule 203 (b)(1).
But f the 3.3 Million fails that were generated while Overstock.com was listed as a threshold security were not being closed out through the “immediate close out” features of Rule 203 (b)(1), what impact would an additional 280,000 shares have on the market if similar type language were applied to those grandfathered fails? No short squeeze on 3.3 million fails but the extra 280,000 now added to the mix is about to throw the market over the edge? I don’t think so!
Similar data on companies under SHO threshold guidelines exists many times over.
Industry Position: Eliminating the grandfather clause will reduce short selling in the markets, restrict bona-fide market making, and increase the cost to borrow on hard to borrow securities.
Dissenting Opinion: Eliminating the grandfather clause has no impact on short selling volume. Short selling by any means other than bona-fide market making requires settlement. Eliminating a provision of time in acceptable settlement failures has no impact on the present laws requiring the settlement of trades in a 3-day window.
Relative to market making, bona-fide naked shorting is intended to cover the temporary volatility in market volume. This can be a matter of minutes during intraday trading or a matter of days if an anomaly occurs. Regardless of whether an indefinite period associated with a grandfather clause exists, the laws continue to allow a 10-day grace period of settlement failure before additional restrictions and close out provisions come into play. This additional 10 days would provide market makers every opportunity to cover their bona-fide short. Beyond 10-days, the volume is no longer temporary and thus the trading becomes a proprietary trading strategy that requires the same trading restrictions as any investor would be required to follow.
It is my opinion that the third category, borrowing rates increases, will in fact take place. The rate increases will be for the wrong reason however.
The perception out there is that .5% of all fails [minimum grandfather threshold] no longer remaining unsettled indefinitely will reduce the number of available shares in the system to short. By not making shares available in the market because they were used to cover what would otherwise be a fail will drive up the price of the borrow.
These higher fees will simply become the higher margins Wall Street can receive for the lending of shares. But since settlement and lending are not directly linked, fees may increase without any reduction in trade settlement failures.
Unless the present fails in the system are limited to market making, every non-market making fail in the system today is by a client short position who paid a fee to borrow a share that was not lent. This fact implies that stock lending fees and trade settlement are not directly correlated except by perception.
Ultimately, the arguments of investors and issuers have a modicum of evidence that supports the accusations lobbied against the industry and the regulators. Regulation SHO has the appearance to have done very little to clean up the number of settlement failures in the system through a process of forcing the immediate closeout of extended failures as written into present day laws. All proposed amendments under comment today would likewise fail in their tracks, as the root issue of “immediate closeout” remains an arbitrary and undefined metric.
The only real solution to secure this market as fair and investor friendly; force the members to respond to trading under the intent of the language written into law; prompt settlement of trades with mandatory and immediate close out of fails extending beyond 13 days. No loopholes, no special exemptions for members, only laws that apply equally to all and with language having only one allowable interpretation.
Regulators need to rid this raging battle by acting responsibly not politically.
For more on this issue please visit the Host site at www.investigatethesec.com .
Copyright 2006
An online newspaper reporting the issues of Securities Fraud
This SHO’s a Bust… - January 18, 2007
David Patch
Rarely is there ever a debate that rages on for such length in time where few facts are ever discussed and where perception is the only measuring stick used by the experts to evaluate progress.
Regulation SHO was drafted and proposed in late 2003 to address present day loopholes in a 70 year old set of laws. Abuses in short selling have increased over the decades as liquidity increased and the regulators were concerned that these failures due to the abusive short selling could be used as leverage to manipulate down the price of securities.
The regulators released Regulation into law in 2004 with an affectivity date of January 2005. The final release was theoretically designed to reduce the settlement failures in the system while in doing so prevent the market volatilities associated with “short squeezes”.
Theoretically!
The battle rages between investors [individuals and issuers] and the industry [regulators, Wall Street members, financial press] over the ultimate success of the 2-year-old law. Most of this battle rages without evidence to support the positions as transparency of data has been lacking.
Biased as I may be to this issue, enough data does exist that implies that the industry is either deceiving the public or has blinders on to the realities of Regulation SHO and success.
Let’s start with a few simple facts.
Industry Position: Regulation SHO was intended to reduce the level of settlement failures in the system. SHO has done that and requires no future changes.
Fact: Information obtained under the Freedom of Information Act provided evidence that the average daily level of fails and the number of companies qualified for the SHO threshold security list has not changed over the first 17 months of the program. This implies SHO has not met the intent of the Commission.
Industry Position: Regulation SHO has policies in place that force short sellers to cover fails after a period of 13 days of consecutive fails if that company is on the threshold security list.
Rule 203 (b)(3) States: If a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency in a threshold security for thirteen consecutive settlement days, the participant shall immediately thereafter close out the fail to deliver position by purchasing securities of like kind and quantity.
Fact: Regulation SHO simply adds tighter shorting restrictions on member firms and their clients as the requirement of “immediately thereafter closeout” was left undefined in terms of immediately. By stating “of like kind and quantity” regulators are allowing Wall Street to apply cost into the factor.
For example, if a fail on a security sold took place with 10,000 shares at $5.00/share, and the present market is $5.50, those shares are not considered of like kind to that sold into a failure. The SEC rule does not require that the $5.50 shares be purchased to close out the $5.00 fails because of the allowed perception that they are no longer of similar kind.
In fact the SEC added a restraint to future short sales by drafting language into Rule 203 (b) stating…
The participant “may not accept a short sale order in the threshold security from another person, or effect a short sale in the threshold security for its own account, without borrowing the security or entering into a bona-fide arrangement to borrow the security, until the participant closes out the fail to deliver position by purchasing securities of like kind and quantity”
But in theory, if the closeout were mandatory and “immediate” there would be no need for this additional stipulation yet it exists. Instead of reliance on members to meet the “immediate” timeframe as we all understand the definition of immediate; the SEC put language into law that allows for Broker Dealers to execute additional short sales while past ones remain on the books as failed. The additional short sales can be used to potentially drive the market back to that theoretical $5.00/share threshold where the closeout could be made without a loss.
Industry Position: Eliminating the grandfather clause of Regulation SHO will unduly cause short squeezes. The grandfather clause referring to those fails that took place prior to a security being listed on the threshold security list and thus not required to meet the “immediate close out” provisions of Rule 203 (b) (1). According to a memo from the SEC’s Division of Market Regulation, “Regulation SHO does not require the close-out of fails to deliver that existed before a stock became a threshold security (known as "grandfathered" securities) because the Commission was concerned about creating volatility through short squeezes if existing positions had to be closed out quickly. “
Fact: Short squeezes are only created when mandatory buy-ins take place, in large quantity, and at any offered market price. In this case, the fears of a short squeeze being are those events where a massive quantity of failed trades are suddenly forced to be settle, but only those now booked as grandfathered fails.
Utilizing data obtained under the Freedom of Information Act, Overstock.com had roughly 280,000 Fails in the system on the day they were first listed on the threshold security list in January 2005. By March 17, 2006 this number had accumulated to 3.6 Million shares. This is an increase of 1185% while theoretically trading under mandatory and immediate closeout provisions of Rule 203 (b)(1).
But f the 3.3 Million fails that were generated while Overstock.com was listed as a threshold security were not being closed out through the “immediate close out” features of Rule 203 (b)(1), what impact would an additional 280,000 shares have on the market if similar type language were applied to those grandfathered fails? No short squeeze on 3.3 million fails but the extra 280,000 now added to the mix is about to throw the market over the edge? I don’t think so!
Similar data on companies under SHO threshold guidelines exists many times over.
Industry Position: Eliminating the grandfather clause will reduce short selling in the markets, restrict bona-fide market making, and increase the cost to borrow on hard to borrow securities.
Dissenting Opinion: Eliminating the grandfather clause has no impact on short selling volume. Short selling by any means other than bona-fide market making requires settlement. Eliminating a provision of time in acceptable settlement failures has no impact on the present laws requiring the settlement of trades in a 3-day window.
Relative to market making, bona-fide naked shorting is intended to cover the temporary volatility in market volume. This can be a matter of minutes during intraday trading or a matter of days if an anomaly occurs. Regardless of whether an indefinite period associated with a grandfather clause exists, the laws continue to allow a 10-day grace period of settlement failure before additional restrictions and close out provisions come into play. This additional 10 days would provide market makers every opportunity to cover their bona-fide short. Beyond 10-days, the volume is no longer temporary and thus the trading becomes a proprietary trading strategy that requires the same trading restrictions as any investor would be required to follow.
It is my opinion that the third category, borrowing rates increases, will in fact take place. The rate increases will be for the wrong reason however.
The perception out there is that .5% of all fails [minimum grandfather threshold] no longer remaining unsettled indefinitely will reduce the number of available shares in the system to short. By not making shares available in the market because they were used to cover what would otherwise be a fail will drive up the price of the borrow.
These higher fees will simply become the higher margins Wall Street can receive for the lending of shares. But since settlement and lending are not directly linked, fees may increase without any reduction in trade settlement failures.
Unless the present fails in the system are limited to market making, every non-market making fail in the system today is by a client short position who paid a fee to borrow a share that was not lent. This fact implies that stock lending fees and trade settlement are not directly correlated except by perception.
Ultimately, the arguments of investors and issuers have a modicum of evidence that supports the accusations lobbied against the industry and the regulators. Regulation SHO has the appearance to have done very little to clean up the number of settlement failures in the system through a process of forcing the immediate closeout of extended failures as written into present day laws. All proposed amendments under comment today would likewise fail in their tracks, as the root issue of “immediate closeout” remains an arbitrary and undefined metric.
The only real solution to secure this market as fair and investor friendly; force the members to respond to trading under the intent of the language written into law; prompt settlement of trades with mandatory and immediate close out of fails extending beyond 13 days. No loopholes, no special exemptions for members, only laws that apply equally to all and with language having only one allowable interpretation.
Regulators need to rid this raging battle by acting responsibly not politically.
For more on this issue please visit the Host site at www.investigatethesec.com .
Copyright 2006