IN THE MONEY: Regulators Say 1-Yr-Old Reg SHO A Success
19 January 2006 14:07
Dow Jones News Service
(c) 2006 Dow Jones & Company, Inc.
By Carol S. Remond
A Dow Jones Newswires Column
NEW YORK (Dow Jones)--One year after its adoption, a new short-selling rule has been successful in significantly improving timely settlement of trades.
Known as Regulation SHO, the rule aimed to modernize short-selling rules and to address failures to deliver stock on settlement date three days after a transaction.
Market regulators said in a series of interviews with Dow Jones Newswires that a sharp decrease of the number of companies on the so-called threshold lists shows the early positive impact of Reg SHO. The regulators also said that ongoing examinations of clearing firms showed that Wall Street firms have abided by the new rule.
"Thus far, there appears to be a good level of compliance," a senior staffer at the Securities and Exchange Commission said. According to the SEC, 99% of all trades in dollar terms settle on time.
On average more than $2 trillion worth of trades settle daily through the National Securities Clearing Corp. and Depository Trust Co., two subsidiaries of the Depository Trust and Clearing Corp., the entity that operates a global electronic clearing system.
Under Reg SHO, which incorporated existing short-selling rules from the New York Stock Exchange and the NASD, exchanges provide daily lists of securities with large amounts of failure to deliver. These lists are known as threshold lists. Once a security gets on the list, it typically becomes harder and more expensive to short the stock. In a short sale, a security not owned by the seller is sold in anticipation of a decrease in the stock price. Typically, brokers executing short sales must first make sure that stock is available for borrow.
Some companies have argued that the existence of threshold lists and the fact that some securities stay on them for extended periods of time indicate that the clearing and settlement system on Wall Street is broken.
A few securities, including Krispy Kreme (KKD) and Martha Stewart Living (MSO), have been on threshold lists since Reg SHO's inception on Jan. 10, 2005.
But regulators said that extended stays on threshold lists are not in themselves indicative of any lack of compliance with Reg SHO. They point to a number of factors affecting the number of long-term or aged fails, including so-called grandfathered fails, a number of exemptions granted to stock and option market makers that provide liquidity to the market as well as delays in the delivery of certain types of securities like restricted 144 stock.
"Just because stocks appear on the threshold list doesn't mean that broker dealers aren't following the rules. It means that they are exercising exemptions under the rules," said Steve Luparello, executive vice president of Market Regulation at NASD.
Reg SHO defines threshold securities by two criteria: There are at least 10,000 shares in aggregate failed deliveries for the security for five consecutive settlement days and these fails constitute 0.5% or more of outstanding shares. Fails existing prior to Reg SHO's adoption last January were grandfathered into the system. That means that pre-existing fails are not subjected to new rules that force market participants to close out trades that have failed to settle for extended periods of time.
"Grandfathered fails may be a significant factor in extended fails," said the senior SEC staffer, adding that the Commission is "analyzing the data to determine whether SHO should be revised in any way."
Data provided by the SEC shows that Reg SHO is having the intended effect of clearing up fails to deliver. Through the end of November 2005, the average daily aggregate fails to deliver for all stocks on threshold lists decreased by almost 40%. Meanwhile, the average daily number of threshold securities declined by 36% and the average daily fails of threshold securities dropped by 41%.
"The industry as a whole has basically done a pretty good job," said NASD's Luparello. He said that clearing firms overall have tried very hard to comply with the new rules.
Regulators said that the SEC, the NASD and the NYSE have worked together in developing examination modules to monitor compliance with Reg SHO.
In addition to routine yearly screening of firms for compliance with SHO and other rules, the NYSE and NASD said they have built automated surveillance systems based on data obtained from DTC.
"To the extent our system has generated an aged fail to deliver exception, we will contact our member firms to determine why the position was not closed out, whether it was a fail relating to a market maker or grandfathered position," said Anand Ramtahal, vice president in the NYSE's division of member firm regulation.
The SEC, NASD and NYSE also conducted a joint sweep examination of two dozens firms to check compliance with Reg SHO.
"We were out very early in the process, as were the SEC and the NASD," NYSE's Ramtahal said.
Under Reg SHO, brokers who fail to deliver a security for 13 consecutive settlement days have to execute mandatory buy-in to clean the fails. If the broker cannot buy-in the security, it and its clients will be restricted from further selling short the security without a "pre-borrow agreement."
But in order to balance the need for orderly and timely settlement of trades with the need for market liquidity, the SEC included a number of exemptions in Reg SHO.
In addition to the grandfathering provision which exempted outstanding fails before Jan. 10, 2005, market makers that provide liquidity to the market are exempt from the locate requirement under Reg SHO. Meanwhile, option market makers who have positions in a security before it got on a threshold list are exempt from closing out fails resulting from short selling positions that market maker made to edge the existing position.
"Our analysis shows that a number of the positions that continue to exist (on threshold lists) for periods of time are hedge or arbitrage activities exempt from the provisions," NASD's Luparello said.
(Carol S. Remond is an award-winning columnist and one of four who write the "In The Money" feature. Most recently, she won a 2005 Gerald Loeb Award for best news service content with "Exposing Small-Cap fraud," a series of articles that described how three small companies unscrupulously pumped up their stocks.)
-By Carol S. Remond, Dow Jones Newswires; 201 938 2074; carol.remond@dowjones.com [ 01-19-06 1407ET ]
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