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July 6, 2009

Exchanges Respond To SEC Short Sale Proposals

By Peter Chapman

If the Securities and Exchange Commission was counting on the operators of the nation's largest market centers to support any of its five short-sale proposals, it can't be happy.

As part of the regulator's proposed changes to Regulation SHO, which governs short selling, it proposed a bid test; a return of the uptick rule; a circuit breaker with a bid test; a circuit breaker with the old uptick rule; and a circuit breaker coupled with a complete ban.

The market centers rejected all five proposals, preferring to champion their own ideas.

At the Securities Industry and Financial Markets Association's annual conference on market structure in May, executives from the four biggest market operators weighed in on the SEC's proposal, meant to check declining markets. Most were reluctant to see new short-sale rules, but felt they were inevitable given the political climate.

"The horse is out of the barn," said Brian Hyndman, a Nasdaq OMX executive vice president, "and we think the SEC is going to do something."

Three of the four exchanges do support a circuit breaker approach, whereby rules kick in only after a particular stock drops 10 percent or so. But from there they diverge from the SEC.

Both Nasdaq and BATS Exchange are calling for a circuit breaker. Under their proposal, once a stock falls by a certain percentage, then a trader can only short by posting an offer. He can't hit the bid. This, they maintain, is a "passive" approach. It contrasts with an aggressive approach whereby the trader can smack the bid. "Passive short selling will allow markets to maintain as tight spreads as possible," BATS's chief executive, Joe Ratterman, told the crowd.

Nasdaq, BATS, NYSE Euronext and the National Stock Exchange were signatories to a letter sent to the SEC in February proposing this idea. It was actually a dusting-off of an old SEC proposal, but the regulator chose not to include it this time in its smorgasbord of choices. Many traders do not like it because it hinders shorting in an advancing market. (The SEC did ask for comment on the proposal, however.)

Joe Ratterman

That's one reason the NYSE says it is not thrilled with passive shorting. "We have heard from stat-arb and algo guys that having the passive test, even with a circuit breaker, would be more destructive to liquidity than a bid test left on all the time," said Larry Leibowitz, NYSE Euronext group executive vice president.

The New York supports a return of the old NASD bid test. Former Rule 3350 is similar to the SEC's proposed bid test, as they both use the consolidated best bid as a reference price. But Rule 3350 is more liberal than the SEC's proposed rule because it allows shorting at any price when stocks are advancing.

"The bid test of the old NASD rule would disrupt the market less than the others," Leibowitz said. "But the challenge is that it is a little more technically difficult to implement." Unlike the circuit breaker approaches, the bid test would apply to all stocks at all times.

The lone holdout in the bunch is Bill O'Brien, chief executive of Direct Edge ECN. He favors no new rules.

As Traders Magazine was going to press, very few of the industry's heavy hitters, including the exchanges, had weighed in on the issue via comment letters. They had until June 19 to do so.


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