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May 6,2009 STA Rejects Trading Limits for Short Sales, Advocates Pre-Borrows http://www.tradersmagazine.com/news/-103725-1.html?page=1 By Nina Mehta TradersMagazine.com May 7, 2009 Unhappy with the five current proposals from the Securities and Exchange Commission to restrict short selling, the Security Traders Association has come up with a sixth. The STA on Monday recommended that the Commission adopt a mandatory pre-borrow triggered by a circuit breaker to restrict short selling. This proposal targets the abusive short selling at the heart of concerns about short sales, which the SEC's current proposals miss, the group said. The STA proposal does this by seeking to curtail short selling by those actively trying to drive down the price of a particular stock. It does not seek to restrict all short-selling activity in that name. However, this proposal also has its skeptics. "The SEC's current options are based on mechanical trading functions, while our proposal will economically impact the short sellers," Peter Driscoll, chairman of the STA and senior equity trader at Northern Trust Company, told Traders Magazine yesterday at the group's annual Washington, D.C., meeting. He said trading constraints based on ticks or bids do not present much of a hurdle for short sellers in a fast-moving market in which bids can move up and down within a single second. The STA advised the SEC not to adopt a trading rule around short selling, but to instead require short sellers to pre-borrow shares for short sales if the stock in question declines 10 percent from the previous day's closing price. In making this suggestion, the STA rejected the five proposals put forth by the SEC last month. These include two price tests (one based on ticks, the other on bids) and three circuit breaker-based solutions intended to constrain short selling. A pre-borrow refers to the need to borrow shares to settle short sales before the execution takes place. Currently, firms must have "reasonable grounds" to believe the shares can be borrowed by the settlement date, which is three days after the trade date, but they do not have to borrow the shares in advance. Under the STA's proposal, exemptions to the re-borrow requirement would be allowed for bona fide market makers in equities and options, as well as for domestic and international arbitrage trades. However, if the stock dropped 20 percent from the previous close, those exemptions would disappear, requiring everyone to pre-borrow shares. At 30 percent, short sales would be banned for the rest of the day. "The current discussions on how to combat abusive short selling and the attributed volatility have been trading-centric," the trade group said in its letter to the SEC outlining its proposal. The STA said tick tests and bid tests have been "rendered ineffective by structural changes to the markets and that price tests would be unable to dampen volatility even if they were to be reinstituted." The SEC eliminated all price tests, including the New York Stock Exchange's uptick rule, in July 2007. At an STA panel on short selling on Tuesday, Driscoll told the audience that "we should promulgate rules for problems, not politics." He said the SEC is responding to political pressure from Capitol Hill and public outcry focused on short selling without differentiating between harmful practices and short selling that is part of legitimate trading strategies. The STA letter noted that its solution addresses the real problem of abusive short selling, which typically involves deliberate naked shorting (in which a short seller makes no attempt to borrow shares to settle short sales). This solution, the group said, also avoids interfering with the price discovery process by not curtailing short selling the vast majority of the time. In addition, the pre-borrow requirement obviates the need for broker-dealers to spend large amounts of money reprogramming systems to cope with a new short-selling rule. Brokers would have to do this to incorporate a price test in their trading systems and to deal with the gush of bids that would have to be properly sequenced. Brett Redfearn, global head of liquidity and algorithmic trading at JPMorgan Securities, said at a public SEC roundtable discussion about short selling on Tuesday that hundreds of bids can occur every second, including directional changes in the bid price. That makes sequencing the bids to determine whether a short sale can be executed difficult. It also subjects a bid-test restriction to latencies in market data feeds. Several panelists at the SEC roundtable noted that in the current world of "microsecond trading," as Redfearn put it, differences in market data feeds loom large. Traders with direct feeds from market centers will see different bids than those who receive consolidated feeds. The STA letter pointed out that this makes price tests "ripe for gaming." Specifically, the letter wondered, "Which data feed speed will set the bid benchmark?" At the STA panel on Tuesday, Driscoll stressed that the SEC needs to act to improve investors' concerns about short selling. "I truly believe we have to do something to improve investor confidence, but this rule is not the right thing," he said of price tests generally. In his view, a pre-borrow would directly address investors concerned about bear raids, in which short sellers try to push down the price of a particular stock through aggressive short selling. He also noted that the SEC could get itself into a bind if a new short-selling restriction is oversold to the public. "[If we] tell investors we're protecting them from something we're not protecting them against," they'll be angry, Driscoll said. Joe Mecane, executive vice president for U.S. markets at NYSE Euronext, who also appeared on the STA panel, did not comment on the group's proposal, but said he didn't think the stock loan market is electronic or efficient enough "to accomplish it on Day One." Locating stocks for short sales is electronic and automated at the biggest prime brokers, but actually borrowing shares immediately to support end-users' short selling is not. Mecane said NYSE Euronext supports a circuit breaker that, if triggered, leads to a bid test for short sales. Alfred Berkeley, chairman of Pipeline Trading Systems and a former president of Nasdaq Stock Market, told Traders Magazine he agreed that the stock loan market isn't ready for a pre-borrow requirement. Eight to 10 firms control the stock borrow business, he said, and "they have motives other than making the market work smoothly and making borrowing easy for everybody." The stock loan business has long been a high-margin business for brokers with large inventories or access to inventory to support short sales. However, Berkeley said, the STA proposal wisely targets the problem of naked shorting at the trading level. The SEC last fall drastically tightened delivery requirements for short sales, imposing penalties on firms that fail to settle trades. Those rules have been effective, but they leave room for abuse when a stock is under duress, according to Berkeley. "The STA has a pragmatic approach to solving a problem, and it's a problem that needs to get solved," he said. The STA's Driscoll acknowledges that broker-dealers' systems cannot currently support automated pre-borrows. "Some systems would have to be developed," he said. "But brokers also aren't ready for a bid test and would have to spend months preparing their systems for that." He added that an unintended consequence of the STA's proposal is that transparency in the stock lending system would benefit a large swath of investors by making the prices for stock borrows more readily available.

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