Part 2 of 3:
D. Recent Developments
Despite the many studies and recommendations, the basic provisions of Rule 10a-1 have remained unchanged for 60 years. Developments in the markets, however, may have diminished the need for the Rule in its current form. Among other things, the national securities exchanges today have high levels of transparency and regulatory surveillance. Transparency helps market participants observe and evaluate market price movements which limits the ability of short sales to unevenly affect prices. The self-regulatory organizations (SROs) also have sophisticated surveillance technologies that allow them to monitor market activity on a real-time basis. This surveillance reduces the risk of undetected manipulation and permits regulators to monitor the types of activities that Rule 10a-1 is designed to prevent. As the markets change, commentators continually question the relationship between the objectives of Rule 10a-1 and its operation.[42]
Short selling is instrumental to a growing number of sophisticated investment models and instruments. For example, short sales are used to hedge option positions and to engage in a variety of arbitrage strategies.[43] Short selling is also integral to other trading and investment strategies that are not tied to individual securities, but involve baskets of securities. The restrictions in the Rule may inject unnecessary inefficiencies into such trading strategies. To accommodate the developments, we have granted a number of requests for relief from Rule 10a-1.[44] The growing array of requests for relief indicate that present short sale regulation may have become unduly burdensome and possibly ill-suited for the present and future markets.
II. Concepts Regarding Short Sale Regulation
In this section of the release, we present for public comment eight concepts regarding short sale regulation: (1) suspending the short sale rule when the security or market is above a threshold price; (2) providing an exception for actively traded securities; (3) focusing short sale restrictions on certain market events and trading strategies; (4) excepting hedging transactions from short sale regulation; (5) revising the short sale rule in response to certain market developments; (6) revising the definition of "short sale"; (7) extending the short sale rule to non-exchange listed securities; and (8) eliminating Rule 10a-1.
We seek comment on these concepts to assist our review of Rule 10a-1 and short selling in the current market. We encourage commenters addressing the concepts in this release to present data to support their positions.
A. Suspending the Short Sale Rule When the Security or Market Is Above a Threshold Price
One objective of short sale regulation is to permit relatively unrestricted short selling in an advancing market. The tick test in Rule 10a-1, however, applies in all market conditions. Thus, even in a generally advancing market, a short sale would be inhibited when the price of the transaction does not permit the seller to meet the tick test.[45] This restriction may allow the prices of securities to advance beyond the prices that the market would reflect if short selling were unrestricted. Some argue that the restrictions contribute to market volatility because prices move up without the checks that unrestricted short selling would provide.
In response to recent criticism of the Rule, we seek comment on suspending the tick test when a security's price is above a threshold.[46] This alternative approach assumes that the current Rule is unnecessarily restrictive in upward moving markets. By suspending the tick test when the security or the market is above a threshold price, short sellers could sell without regard to price movements. The tick test would apply, however, at any time the price of the security (or a market index) went below the threshold (i.e., the tick test would apply at prices below the threshold). We request comment on this concept to determine if such an alternative is consistent with the Rule's objective to allow relatively unrestricted short selling in an advancing market.
We further request comment on what benchmark would be appropriate for establishing the threshold price discussed in this alternative approach. One possible benchmark is the previous day's closing price of a security.[47] Another possible benchmark could be a percentage decline in the price of the security. For example, the threshold could be 5 percent or 10 percent below the previous closing price of the security. A general market indicator also could be used as a benchmark. For example, the tick test's application could correspond to the operation of SRO rules that impose limitations when markets experience significant declines.[48] Once the market indicators crossed the threshold, the tick test would apply.
Q1. Does Rule 10a-1 permit relatively unrestricted short selling in an advancing market? If not, please provide specific examples to demonstrate that this objective is not currently met.
Q2. Does more short selling occur in an advancing market or a declining one?
Q3. Should the threshold price for suspending the tick test be the previous closing price of the security?
Q4. Should the threshold price correlate to a point change or a percentage change in the price of a security?
Q5. Would volatile markets create complexity for this structure as short sellers must continually take into account the market price of the security to determine whether short selling is restricted?
Q6. If the security's price moves below the threshold price, should the tick test remain in effect during the trading session even if the price subsequently moves above the threshold price?
Q7. Is there another price or manner of determining a more effective threshold for this purpose?
Q8. Could a short seller initiate downward momentum on the price of a security through short selling down to the threshold price? If so, could this momentum cause the depressing effect on the market for a security that Rule 10a-1 is intended to prevent?
Q9. Is it appropriate or preferable to base short sale regulation on general market movements, rather than the price of individual securities?
B. Providing an Exception for Actively Traded Securities
Some of the Commission's anti-manipulation rules assume that highly liquid securities are less vulnerable to manipulation and abuse than securities that are less liquid. For example, Rule 101 of Regulation M has an exception for securities with a public float value of at least $150 million and an average daily trading volume of at least $1 million.[49] A similar approach may be effective for regulating short sales.
Q10. Are highly liquid securities less vulnerable to the abuses that Rule 10a-1 is designed to prevent?
Q11. Are the Regulation M requirements for liquidity under the exception in Rule 101(c)(1) adequate standards for this purpose? If not, what values would work better for this purpose?
Q12. Rule 10a-1 is not focused solely on preventing manipulative activity. Is it appropriate to use these anti-manipulation approaches in the short sale context?
C. Focusing Short Sale Restrictions on Certain Market Events and Trading Strategies
Certain market events and trading strategies may make a security more vulnerable to abusive short sale activity. The Commission previously has recognized that certain events increase the potential for short selling abuse.[50] Specific market events related to an issuer or a security (such as a pending merger or acquisition) may cause this increased vulnerability. Also, there may be certain times in a trading day when there is a heightened concern about manipulation.[51] We, therefore, request comment on whether short selling should continue to be regulated or even prohibited during specific market conditions.
Q13. Are there corporate events (e.g., mergers, acquisitions, or tender offers) that make a security vulnerable to abusive short selling?
Q14. Are there other cyclical, or regular market events (e.g., option expiration dates or the opening and closing of a trading session) that make a security vulnerable to abusive short selling?
Q15. Are there other trading abuses or manipulations involving short sales under unusual market conditions that Rule 10a-1 currently does not address? If so, could the Rule be amended to prevent these abuses?
Q16. Should short selling be prohibited for a period preceding a significant corporate or market event?
Q17. If the Rule was eliminated, should restrictions continue to apply preceding a significant corporate or market event?
D. Excepting Hedging Transactions From Short Sale Regulation
Today, short selling is integral to many complex trading strategies involving a variety of sophisticated financial instruments. Short sales are often used in these strategies to hedge a position in another security or a related financial instrument. Short positions and short sales related to such hedges are treated the same under Rule 10a-1 as any other short activity. Complying with Rule 10a-1 potentially increases transaction costs on persons using short hedging because of delays caused by waiting for upticks. The risks of a particular strategy, therefore, also may increase as a result of the Rule. We seek comment on whether hedged short positions should be excluded from calculating a person's net position. We also seek comment on whether we should propose adding an exception to Rule 10a-1 that would cover short sales conducted exclusively for the purpose of establishing a bona fide hedge.[52]
Q18. Is the definition of "bona fide hedge" currently used by the Commission appropriate and adequate?
We have received a number of inquiries seeking relief from Rule 10a-1 for short sales that are part of a bona fide hedge. Proponents argue that it is unlikely that short sales used to create bona fide hedges present a threat of manipulation because gains from the short position would be offset by losses in an equivalent security, i.e., they are "economically neutral."[53] Rule 10a-1 currently may inhibit such short sales even though they present little risk of the abuses that it was designed to guard against. We have provided exceptions from and interpretations of Rule 10a-1 for economically neutral short sales that do not present an incentive for abuse.
Rule 10a-1 presently provides exceptions for:
(i) bona fide arbitrage[54] undertaken to profit from a current difference between a convertible security and the underlying common stock;[55] and
(ii) bona fide arbitrage undertaken to profit from a current difference between the price of a security in the United States and its price abroad.[56]
Both of these exceptions allow short sales without compliance with the tick test, where the sales are to take advantage of temporary price differentials between related securities or different markets.
Rule 10a-1 also has a limited exception for block positioning activities by broker-dealers.[57] This exception permits a broker-dealer selling securities that it acquired as a block positioner to disregard, in determining whether it is net long or net short, proprietary short positions to the extent those short positions are the subject of one or more offsetting positions created in the course of bona fide arbitrage, risk arbitrage,[58] or bona fide hedge activities. The Commission relied upon the premise that the short positions excluded from the calculation are not subject to the same potential for abuse as short positions that are not linked to an offsetting position.
We recently granted relief for certain specialist activities that expands on the aggregation relief discussed above. [59] The exemptions provide greater flexibility where short positions are subject to bona fide hedges. As with the block positioner exception and the Merrill Lynch Letter, [60] the exemptions exclude hedged short positions from the calculation of a net position. In addition, the short sales were limited to the specialists' performance of obligatory market functions.
Using a rationale similar to that underlying the limited exception for block positioning activities, our staff took a limited no-action position to facilitate unwinding certain index arbitrage positions with a long stock component. This relief from the tick test applies to broker-dealers unwinding long index arbitrage positions. As with block positioners, this no-action position was limited to circumstances where the sale of securities was deemed a short sale solely as a result of the netting of the index arbitrage long position with one or more short positions created in the course of arbitrage or hedging activities. These securities positions were considered economically neutral, and the unwinding of the index arbitrage position was not thought to involve the types of abuses that Rule 10a-1 was designed to prevent. In these contexts, the staff assumed that economically neutral transactions do not present the incentive to engage in short sales in a manner that would cause or accelerate a decline in the market, because any gain from the short stock would be offset by a loss in the security or securities making up the bona fide hedge or arbitrage position.[61]
Q19. Should the Commission exclude hedged short positions for the purposes of determining what a person's net position is under Rule 3b-3?
Q20. Should long stock positions that are fully hedged be excluded from the calculation of a person's net position in that stock?
In addition, we have received requests for relief from Rule 10a-1 to permit short sales that are part of trading strategies conducted to establish bona fide hedges. Many of the strategies use statistical formulas or relationships between or among securities to determine the offsetting transaction for the hedge. For example, the purchaser of a convertible security may short the underlying security to hedge against a potential decline in the price of the underlying security. The short sales used in these strategies are distinguishable from short sales that reflect an opinion about the current or future market price of a security.
A broad array of financial instruments can be hedged using short sales of securities. These instruments may not be related to the security sold short, but they nonetheless are economically equivalent. Because of the potential variety of instruments that may be hedged with short sales, we believe that an exception would have to be crafted broadly enough to afford flexibility. For example, the Rule could except short sales that are conducted to offset "qualified financial contracts" (QFC), using the definition in the Federal Deposit Insurance Corporation Act that includes "any securities contract, forward contract, repurchase agreement, swap agreement, and any similar agreement...."[62]
Q21. Should a broad exception covering short sales offset by equivalent securities be proposed? If so, what securities should be considered equivalent?
Q22. Is "economic neutrality" the proper basis for such an exception? If not, what types of relationships (using a short hedge) that appear to be economically neutral present a potential for manipulation that Rule 10a-1 is designed to prevent?
The relationship between a short position and the instrument hedged by the short position will vary according to custom and practice. Firms that are more tolerant of risk may not fully hedge a position. Instead, they may use a ratio hedge that reflects their tolerance of risk. Such hedging techniques may be difficult for regulatory agencies to evaluate and determine whether a particular hedge should be viewed as a bona fide hedge.[63]
Q23. Should an exception for hedging transactions be limited to transactions or positions that involve a complete hedge? If so, how should a complete hedge be defined and measured?
Q24. What type of surveillance should the Commission consider for monitoring short sales conducted as part of economically neutral transactions?
E. Revising the Short Sale Rule in Response to Certain Market Developments
If Rule 10a-1 is retained (in whole or in part), certain basic adjustments may be required to keep pace with changes to the operation of the national securities exchanges. We request comments on two potential changes: expansion of trading hours into after-hours trading sessions and conversion to price quotations using a decimal format. Please comment on any other changes to the operation of the national securities exchanges or alternative trading systems (ATSs) that you believe may affect the regulation of short selling.
1. After-hours Trading Sessions
Securities trading is rapidly expanding beyond the regular trading hours of 9:30 a.m. to 4 p.m. This evolution is manifested by the proliferation of trading in ATSs and consideration of extended trading sessions by both the NYSE and Nasdaq. As in regular hours trading, short sellers could add liquidity and contribute to pricing efficiency in after-hours trading.
The tick test of Rule 10a-1 currently operates relative to the last reported price on the Consolidated Tape. If the Consolidated Tape does not operate after the close of regular trading hours, short sales can only be executed at a price above the closing price on the Consolidated Tape for the security (or, at the closing price if that price was an uptick). This result could greatly limit the ability to execute short sales in after hours trading.
We note that Rule 10a-1 permits exchanges to use the price of the last transaction on the exchange, rather than the last price reported to the Consolidated Tape, as the last reported price. Thus, an exchange operating an after-hours session could rely on this provision. ATSs cannot rely on this provision. Thus, short sales through ATSs must use the last price reported to the Consolidated Tape.
Q25. If the Consolidated Tape does not operate during after hours trading, should we consider adopting an exception to permit each ATS to use the last transaction in its system as the reference price?
Q26. What impact would multiple permissible prices at which short sales could be executed have on the effectiveness of short sale regulation?
Q27. If a number of ATSs all operated using their internal prices for Rule 10a-1 compliance, each could produce a different "closing" price at the close of trading on the ATS. How would multiple after-hours "last sale" prices affect the first trade in the morning trading session when the Consolidated Tape recommences operation?
2. Decimalization
We also note that the securities industry is targeting June 30, 2000, as the date when price quotations will be expressed in terms of decimals rather than fractions. Decimal pricing may result in exchanges setting the Minimum Price Variation (MPV) (i.e., the smallest amount by which the price of a security can change), which today is 1/16 ($.0625) for most equity securities, at one cent or potentially even smaller. A further result of the use of smaller MPVs is that the short sale rule may be triggered by a change in price that, on a percentage basis, could reflect an extremely small decrease in the price of the security. For example, the average price per share traded on the NYSE for June 1999 was approximately 45 7/8. In an environment where the MPV is 1/16, a decrease in the share price by 1/16 (.136%) would trigger the short sale rule. In an environment where the MPV is one cent, the short sale rule would be triggered by a decrease of the share price by 1/100 (.02%).
At least one study has analyzed the effects of smaller spreads on the operation of Rule 10a-1.[64] The study concludes that smaller increments, such as one cent, would improve execution quality for certain short sales and hurt others.
Q28. How did the recent decrease in the MPV from 1/8 to 1/16 affect short selling?
Q29. How will the potential use of a smaller MPV affect the operation of Rule 10a-1?
Q30. Is a price change as small as one penny per share the type of market impact that the short sale rule is designed to prevent?
Q31. Would the use of a smaller MPV support modifying or eliminating Rule 10a-1?
Q32. Should Rule 10a-1 be altered to remain effective with respect to smaller MPV? |
