Covering a client short where the money was put up, but the stock was not borrowed.
When a broker shorts a stock he must borrow the stock. When a client shorts a stock, he must ask for 50% margin, but is under no obligation to cover the short with a borrow, or a purchase of the same stock, although he should.
On September 7, 2007, Market Regulation Services Inc. (RS), which administers and enforces trading rules for Canadian marketplaces (including the TSX, TSX Venture Exchange, CNQ and ATS systems), published for comment a series of proposed changes to the existing rules governing short selling. The proposals were subject to a one-month comment period that expired on October 9, 2007.
Most significantly, these proposed rules would repeal the existing "tick test"—in other words, remove the restrictions on the price at which a short sale may be made. Under the current rules, market participants may not generally make a short sale of a security that is not inter-listed on U.S. markets unless the price is at or above the last sale price for that security (normally determined by reference to trading information from the principal market for that security). The proposed rule would, however, provide a new discretion to RS to designate a security as ineligible to be sold short. RS has indicated that it would expect to exercise that discretion if, in its view, there is evidence of excessive "failed trade" rates in a security, and that the discretion would be exercised only with the agreement of the applicable Canadian securities regulators.
Another important proposed change, from the perspective of market participants, is to remove the requirement that they file twice-monthly short-position reports, subject to the future general availability of information on short sales. RS has indicated that, in its view, the availability criteria will be met if third parties regularly (that is, no less frequently than semi-monthly) disseminate periodic summary reports of short sales effected on marketplaces in particular securities. In this regard, it is anticipated that marketplaces would compile the information on short positions using trade markers that require short sales to be identified as such.
The proposed rule changes would also require market participants to get RS approval before varying or cancelling a trade, and to report to RS if a trade that has failed to settle on the settlement date remains unresolved for 10 trading days following the settlement date, with a second report to be filed once the default has been cured. RS would have the discretion, in certain circumstances, to cancel failed trades. It is anticipated that this discretion would most likely be exercised when trades remain unsettled within 15 days of the settlement date and there appears to RS to be no valid reason for the continuing default.
These proposed rule changes follow a study of short selling rules begun by RS in October 2004, which encompassed, among other things, a close review of evolving short selling rules and market impact studies conducted in the United States, the United Kingdom and elsewhere. In particular, RS conducted a significant study in 2006 on failed trades in Canadian marketplaces using data from 25 dealers. The study found that, among other things, failed trades accounted for only 0.27% of the total number of trades executed by the study participants; less than 6% of fails resulting from the sale of a security involved short sales; and fails involving short sales accounted for only 0.07% of total short sales. The study also found that the predominant cause of failed trades was administrative delay or error and that approximately 96% of the failed trades examined were settled within 10 trading days of the expected settlement date.
The proposed Canadian rule changes also follow a significant recent change in U.S. marketplaces: the July 2007 Securities and Exchange Commission’s repeal of tick tests in all U.S. marketplaces. The U.S. repeal itself followed considerable market study and analysis by the SEC, including the two-year SHO Pilot Project, which focused on stocks contained in the Russell 3000 index. When the SEC announced the repeal of tick tests, RS implemented a rule change to remove the tick tests for inter-listed securities to eliminate inconsistencies between Canada and the United States. This change was effective when compliance with the new U.S. rules became mandatory.
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