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May 10, 2006

Traders Say Continue Short-Sale Pilot Program

By Gregory Bresiger

The Securities and Exchange Commission's year-long Regulation SHO pilot program, under which certain short-selling restrictions were eliminated, will expire this month.

Several trading executives privately told Traders Magazine they hope the program will be extended.

"It has worked out very well. We hope that it will be continued," said one trading executive. "I hope it is now expanded to more stocks," said another trading pro.

The pilot came out of the SEC's Division of Market Regulation and began last May. The SEC allowed some 1,000 [listed and Nasdaq] stocks of the Russell 3000 to be shorted on a downtick.

The pilot also allowed traders to short Nasdaq stocks without performing a bid test. Prior to the pilot, stocks could be shorted on a zero plus tick or a plus tick for listed stocks. And they could be shorted on any down bid on the OTC side. The pilot also allowed the Nasdaq companies in this pilot to be exempted from the bid test rule.

Nasdaq's bid test, put into effect in 1994, prohibits short sales by NASD members in Nasdaq NMS securities at or below the current best (inside) bid when that bid is lower than the previous best (inside) bid.

A security transaction executed at a higher price than the previous transaction is called a plus tick. A price which is the same in the previous transaction price, but is greater than the most recent different transaction price is called a zero uptick (or a plus tick), the opposite of a zero minus tick. Short sales normally only can be executed on an uptick or a zero plus tick.

"They removed the bid and the tick tests in a subset of stocks and basically they found no harm," said one trading desk executive. "They found that these tests don't do much of anything except constrain liquidity," he added. Agreeing with others, he called for the SEC to expand the SHO pilot to all stocks. "Let's go for the gusto here," according to the trading executive.

One of the regulators' stated goals in running the pilot is to measure the impact of short-selling in the absence of a price test.

"This data," the SEC wrote in approving the project last year, "will assist in determining the extent to which a price test is necessary to further the objectives of short sale regulation...." Although the order mentioned other justifications for the pilot, several trading executives said that the pilot should be continued because they see its success as leading to the end of all short sale regulations.

"All short sale rules are really outdated and should be junked," said a trading executive. "Clearly, absence of the rule in part of the market over the past year has not left the market vulnerable to manipulation or any of the nightmares that the rule was designed to thwart," another executive added.

The SEC, in recently approving the Nasdaq exchange application, wrote the "empirical data obtained from the Pilot Program will help the Commission assess whether it is necessary or appropriate to amend, or possibly remove, the short sale tests for some population of securities."

An SEC spokesman declined comment, saying the agency was still compiling information on the pilot.

Trading executives also said that pilot has produced more liquidity on the short side. Jettisoning the tick tests, they said, produces balances in markets. It means that volatility is more "symmetrical," one executive noted.

When there is more liquidity on the buyside than the sellside, they noted, then there is a strong possibility of upside volatility because the sellside is constrained.

"You have systematical volatility with tick tests," said one trading chief. "Rallies that are protracted and overdone can't be damped down."

The uptick rule was adopted toward the end of the Great Depression in 1938. It was put in place because some blamed The Crash of 1929 on short selling, a point of great historical controversy.