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January 2, 2007

Market Makers Under Short Sale Scrutiny

By Peter Chapman

The NASD, detecting abuse, is warning market makers not to circumvent its short-sale rules.

The regulator issued a notice in September reminding members that its rules permit shorting on a down tick only when engaged in "bona fide" market-making activities. The warning was followed last month with stern words from the NASD's new head of market regulation (see following item).

"Our concern is that people are registering as market makers just to get the [short sale] exemption," said Tom Gira at the Security Traders Association's annual conference. "But the exemption is limited to bona fide market making."

The NASD's Rule 5100 generally prohibits shorting Nasdaq-listed securities in over-the-counter transactions at a price equal to or below the inside bid if that quote is below the previous inside bid. The rule provides an exemption to broker-dealers engaged in "bona fide" market making.

For purposes of the rule, bona fide market making, in part, is defined by the width of a dealer's spread, or the difference between his best bid and offer.

The NASD states it does not want to find a market maker that posts "continually at or near the best offer, but does not also post at or near the best bid."

Gira explained that the NASD is seeing firms that quote normally on the offer, but use "stub" quotes on the bid. A stub quote may be a bid of a penny or an offer of $199,999.99. Market makers must make two-sided markets in their stocks, but the size of their spreads is not regulated. "Because of the removal of the excess spread rule," Gira said, "it is very easy to hide in the weeds and not contribute much."

The rule, eliminated in 1997, banned dealers from entering quotes whose spreads the NASD deemed too wide."It's very easy to hang on the box and never really provide liquidity, yet benefit by being an exempt market maker," Gira said. A true market maker is not "somebody who goes in the box and all they do is sell."