G'night'Stalker, whining to the SEC.
These are the guyz, whose CEO admitted to trading against their own clients. If they're against it, you know it's got to be in 'we the people's' best interest.
PS, Liquidity, my azz...additionally, they should make them honor their bogus bid-asks, on the otc-bbs.
S.
from Knight trading - re/SEC REG-SHO
Knight Trading Group, Inc.
John H. Bluher
Executive Vice President
General Counsel
January 6, 2004
Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549-0609
Re: File No. S7-23-03 - Proposed Regulation SHO
Release No. 34-48709 (Oct. 28, 2003), 68 FR 62972 (Nov. 6, 2003)
Dear Mr. Katz:
Knight Trading Group, Inc. ("Knight") welcomes the opportunity to provide our comments to the Securities and Exchange Commission ("Commission") on proposed Regulation SHO. As a general matter, Knight supports the Commission's effort to replace the disparate short sale requirements that exist under Commission rules and the rules of various self-regulatory organizations ("SROs") with a set of uniform requirements.1 We are concerned, though, that specific features of the proposal will impose unnecessary restrictions on over-the-counter ("OTC") market makers that will undermine their ability to provide critical liquidity, especially in less liquid stocks listed on the Nasdaq Stock Market ("Nasdaq").
Market makers perform an essential service by providing market liquidity in their registered stocks. Their effectiveness as liquidity providers, though, depends upon having the flexibility to engage in short selling activity when acting in their market maker capacity. Thus, Knight urges the Commission to exempt bona fide market making from the operation of the proposed bid test and delivery requirements based upon the definitions of "market maker" and "bona fide market making activity" along the lines we propose below. This approach, we believe, will provide meaningful constraints on market maker short selling practices because of the inherent standards a market maker must follow to fulfill its trading obligations, most notably the obligation to provide continuous two-sided markets. Providing an exemption for market makers will permit them to adjust their inventory and risk profiles in a way that will permit them to continue to provide liquidity at the times that inevitably occur when market conditions require a significant commitment of capital and concomitant management of risk.
The Commission's preliminary decision not to exempt market makers from the proposed short sale price test (the uniform bid test) is of particular concern. It represents a significant departure from current practice with respect to Nasdaq NMS securities, in that the National Association of Securities Dealers, Inc. ("NASD") exempts Nasdaq market makers from its short sale price test (as well as other short sale restrictions). If adopted, the restriction will greatly discourage bona fide OTC market making activity in Nasdaq NMS securities. Moreover, the restriction rests upon the faulty assumption that market makers rarely if ever need to sell to the inside bid to fulfill their market making obligations. Other proposed restrictions will also needlessly inhibit prudent market maker behavior, to the detriment of market liquidity, and should be reconsidered.
I. Knight's Standing as a Market Maker
Knight has extensive OTC market making experience in both Nasdaq and exchange-listed stocks through our two subsidiaries, Knight Equity Markets, L.P. ("Knight Equity") and Knight Capital Markets, LLC ("Knight Capital"). Knight is unique in that OTC market making constitutes our primary business, which we perform on a wholesale basis providing essential liquidity to other broker-dealers and institutions. Unlike most other market makers, we are not part of an integrated broker-dealer where market making is an adjunct to the brokerage or investment banking business.
Knight Equity is registered with the Nasdaq Stock Market ("Nasdaq") as a Nasdaq market maker in all Nasdaq-listed stocks. It is, by far, the largest market maker in terms of the number of stocks it trades as well as the volume and number of trades it executes. In 2003, Knight Equity traded almost 381 billion shares of Nasdaq stocks. Knight Capital is registered with Nasdaq as a CQS market maker for all exchange-listed stocks trading in the Nasdaq InterMarket. In 2003, it traded almost 59 billion shares in exchange-listed stocks. We have gained a thorough understanding of how the U.S. equity markets operate from these activities, and are frequently called upon to offer our views on issues relating to market structure and market making. We have drawn upon our extensive experience in formulating our comments.
II. Comments
A. General
The Commission has identified several problems with short selling that Regulation SHO is intended to address. First and foremost, the Commission cites the traditional concern that short selling can be used to manipulate stock prices by exhausting displayed bids or trading at successively lower prices to convey a false impression that an issuer is experiencing problems, thereby inducing others to sell the stock, further depressing the stock's price. Second, the Commission raises the related concern that unrestricted short selling could exacerbate a stock's price decline in a down market, apart from any manipulative intent. Finally, the Commission expresses concern that "naked short selling" in which the seller does not borrow the securities needed to meet its delivery obligation can result in a significant number of delivery failures within the clearing system, which may remain open for an extended time.
At the same time, the Commission recognizes that short selling provides two important benefits to the equity markets. First, it allows market makers (and other market participants) to provide liquidity to the markets. Indeed, the very function of a market maker is to provide liquidity by "[holding] himself out ... as being willing to buy and sell [a] security for his own account on a regular or continuous basis."2 Market makers could not meet their affirmative trading obligations without the ability to sell short. Second, short sellers are seen to contribute to pricing efficiency because their transactions signal their evaluation of a stock's future performance to the market, which absorbs and reflects that information in the price of that security.
The Commission's challenge is to adopt short sale requirements that mitigate the potential for abuse without jeopardizing the recognized benefits of short selling. Regulation SHO does not meet that challenge. As explained in the following sections, Regulation SHO would impose material new restrictions on short selling by OTC market makers that will significantly impair their ability to provide the liquidity that investors have come to expect as a matter of course. Most notably, these include the proposed uniform bid test and delivery requirements, both of which are more restrictive than existing standards imposed on Nasdaq market makers and, unlike the NASD rules they would supercede, contain no exemption for market makers.
We also believe that the short sale problems the Commission has identified, while unquestionably serious, occur on an infrequent basis relative to total market activity. It is our understanding that a small number of issuers and investors have complained about short selling abuses, but that their concerns are largely confined to trading in so-called "micro cap" stocks.3
Our comments focus on the OTC markets for Nasdaq stocks, where proposed Regulation SHO will have the most profound impact by eliminating the market maker exemption and further restricting the bid test. Although third market makers have traded without the benefit of a market maker exemption since the 1970's, due to important differences in how Nasdaq stocks are traded compared to exchange-listed stocks, we do not believe this experience dictates eliminating the exemption for Nasdaq stocks. Nasdaq stocks are traded in a highly electronic environment that relies upon multiple competing OTC market makers as the primary pricing mechanism. However, over the past several years there has been a significant reduction in the number of firms making markets and the number of stocks they cover in large part due to the steady decline in market making profits since 2000.4 This poses a real threat to rigorous inter-dealer competition at least in less liquid stocks below the top tier of Nasdaq 100 stocks. Proposed Regulation SHO will impose significant costs that will further erode market making profits and, in the process, weaken inter-dealer competition as existing firms commit even fewer resources and energy to OTC market making and prospective new market making firms find the costs of entry too substantial.
In contrast to Nasdaq stocks, most trading in exchange-listed stocks occurs on the primary exchange markets; approximately 80% of the share volume in New York Stock Exchange ("NYSE") listings, in fact, is executed on the exchange. While third market makers such as Knight Capital are an important source of additional liquidity, the NYSE still constitutes the primary pricing mechanism for its listed stocks. There is no facility in the third market which is the equivalent of SuperMontage or which imposes similar burdens on third market makers. Thus, third market makers do not have the same price discovery role as their counterparts for Nasdaq stocks, with a correspondingly lesser need to anticipate price changes. That said, we believe that the changes we recommend to Regulation SHO will promote and preserve the competitiveness of third market makers as viable alternative markets to the primary exchanges by providing them with greater latitude to compete more effectively without compromising the Commission's underlying regulatory objectives.5
Moreover, we believe it is important for the Commission to have a uniform short selling rule in all public markets where equities trade. This is of particular concern should the Commission approve Nasdaq's application to register as a national securities exchange with its decentralized competing dealer structure intact. With differing short sale rules for listed and non-listed stocks, the exchange application approval would create new burdens on market makers without any corresponding change in market structure.
B. Need for a General Market Maker Exemption
In lieu of imposing new restrictions on market makers, we believe a better approach would be for the Commission to provide market makers flexibility to engage in short selling, but to limit that relief to transactions that constitute bona fide market maker trading activity. Those functions, properly performed, in and of themselves guard against the risk of market makers engaging in abusive short sale practices.
Under Commission and SRO rules, market making generally entails the obligation on the part of a market maker to provide continuous markets in its registered stocks.6 This means that a market maker is required to enter and maintain a two-sided quotation for each stock in which it is registered.7 The very nature of the quoting obligation mitigates against short sale abuses: it prevents a market maker from quoting on the sell side of the market alone, without providing some counterbalancing trading interest on the buy side (for at least one normal trading unit). Market marker quotes must be firm8 and must also be competitive and bear a reasonable relationship to the prevailing market,9 providing further constraints on market maker short selling activity. Finally, a market maker has a strong incentive to perform its market maker functions in accordance with applicable SRO and Commission rules: the risk of losing its market maker registration in a stock if it does not.10
We propose that the Commission add definitions for the terms "market maker" and "bona fide market making activity" to Regulation SHO to delineate trading activity eligible for a market maker exemption from various provisions of the regulation. We believe the definitions should contain the following elements:
1. Market Maker. We recommend defining this term to cover any dealer that (i) is registered as a market maker in good standing under the rules of an SRO, (ii) holds itself out as willing to buy and sell the securities in which it is registered for its own account on a regular or continuous basis, and (iii) publishes competitive, continuous two-sided quotations in its registered stocks in accordance with applicable SRO rules. This definition is consistent with market maker definitions in other Commission rules and incorporates SRO requirements as further controls. It would also exclude certain market professionals who are deemed market makers for purposes of the Commission's net capital rules, but who do not publish continuous two-sided quotations.
2. Bona Fide Market Making Activity. We recommend defining this term to cover transactions by a market maker as part of a course of dealing consistent with its obligations under the market maker definition, including activity to position the market maker's inventory for anticipated order flow. A skilled market maker will adjust its inventory to hedge anticipated changes in market conditions. For further clarity, the definition could set out that transactions relating to speculative selling strategies or investment decisions or that are disproportionate to the needs of the market (under a facts and circumstances analysis) do not constitute bona fide market making activity. This is comparable to the standard that the Commission proposes in Rule 203(b)(2) of Regulation SHO for a limited market maker exemption from the locate requirements, but with one important change: we believe that a market maker's trading activity should be evaluated in light of prevailing market conditions rather than its past trading patterns.11
These definitions would capture the safeguards against short selling abuses inherent in bona fide market making, obviating the need for the Commission to impose separate short sale restrictions on such trading activity. By focusing on the market maker function, this approach also has the advantage of avoiding unnecessary constraints on legitimate short selling by market makers that could seriously impair market liquidity. In the following sections we explain why certain proposed terms in Regulation SHO would have that unintended effect.
C. Uniform Bid Test
1. The Commission Should Exempt Bona Fide Market Making Activity
The Commission is proposing a short sale price test in Rule 201 of Regulation SHO, called the uniform bid test, which would apply to all exchange-listed and Nasdaq NMS stocks, wherever they are traded. Under this test, a short sale in a covered stock could occur only at a price at least 1¢ higher than the best bid reported for the stock on the consolidated tape at the time of the sale. Proposed Rule 201 would replace the current tick test under Commission Rule 10a-1 for listed stocks and the NASD bid test for Nasdaq NMS stocks under NASD Rule 3350.
The Commission's bid test poses special problems for Nasdaq market makers. The Commission is proposing a small number of narrow exemptions, but has decided at this time not to provide an exemption for bona fide market making activities. Its stated reason is that "a market maker should rarely need to sell short at or below the bid in its market making capacity."12 We strongly disagree. Market makers routinely face trading conditions where they need the flexibility to, and do, sell to the bid to fulfill their market maker obligations. We wish to highlight three real life scenarios:
1. A market maker, in managing its inventory, needs the ability to sell short to the bid in a fast rising market. During dramatic upswings, a market maker may not be able to establish a large enough long position to avoid going short to satisfy customer demand. In this event, the market maker may wish to increase its short position at what it believes is the end of the upward run in order to increase its average price for the short position. When the prices start to level off, though, the market maker will likely only be able to sell short against the bid, as it becomes harder to find buyers willing to pay more than the bid. If the market maker is not allowed to do so, it will find it difficult to sell short at or near the high end of the run, thereby realizing a lower average price on its short sales and greatly increasing its risk of incurring a loss when it covers the short position. To illustrate, if a stock's price increases rapidly from $20 to $25, a market maker might realize an average short sale price for 100,000 shares at $22.50, after selling shares to investors at all price increments, including $21 and $22. At this point, the market maker has an unrealized loss of $250,000 as a result of providing liquidity to investors during the rising market. If the market maker believes the market has topped out at $25, it may wish to sell short 50,000 additional shares at that price to increase its average price from $22.50 to $23.33. By doing so, the market maker could cover the short position at $23.33, or lower, to avoid a serious trading loss if the market price goes down to that level. Restricting a market maker's flexibility to try to adjust its position at $25 by selling to the bid will add to market making risk and cause a market maker to provide less liquidity during the stock's move from $20 to $25, at precisely the time it is most needed.
2. The bid test would also create substantial market inefficiencies when the market is locked or crossed, which the Commission's proposed trade through exemption would not relieve.13 For example, suppose a market maker is bidding at 20 and the market is falling. Another market maker that wishes to offer at 20 or less cannot hit the 20 bid if it has to sell short in order to do so. Moreover, anti-trust considerations preclude it from contacting the first market maker to ask it to change its aberrant quote.14 The market maker is also effectively precluded by NASD rules from locking the market.15 Even if the NASD changed its rules to permit a market maker to lock markets, the Commission's proposed trade through exemption would be unavailable to the market maker that initiates the lock. In short, the Commission's proposal will allow an inattentive market maker to interfere with efficient market functions with an off-market bid for as few as 100 shares and will likely result in more persistent locked and crossed markets.
3. Based on our experience, at times market makers need to be able to sell short at or below the bid to adjust their positions quickly in anticipation of changing market conditions. We believe that the Commission is too quick to dismiss the NASD's findings to this effect in its 1997 study analyzing the market maker exemption from the NASD's short sale rule.16 The bid test will inhibit a market maker's ability to manage the timing of its inventory adjustments in a cost effective manner, potentially resulting in higher costs that will likely be passed on to investors in the form of higher spreads. For example, as an anticipatory hedge, a market maker may wish to short stock so that it is prepared to buy as much as prudently possible from expected sell orders. |
