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July 15, 2007

Market-Maker Liquidity Endangered?

By Peter Chapman

Market makers will have to think twice about putting on some short positions in the wake of a decision by the Securities and Exchange Commission to abolish a loophole in its Regulation SHO.

Among last month's changes to the rules governing short sales, the SEC eliminated the so-called grandfather clause of Regulation SHO's Rule 203. That exception let traders avoid delivering securities they had sold short if they put on their trades after those securities became part of an exchange's "threshold" list. The grandfather clause allowed market makers to short hard-to-borrow stocks without fear they would have to close out losing positions.

The new requirement to close those positions could affect decisions to provide liquidity in those names. "If you eliminate the grandfather provision," said Len Amoruso, Knight Capital Group's chief compliance officer, "you restrict further a market maker's ability to do his job to provide liquidity when investors are looking for it." He added: "With no grandfather provision, market makers must really consider very carefully whether they should commit liquidity to buy orders when they come in."