Subject: FW: File No. S7-24-99
Date:    02/09/2000 1:49 PM
Mr. Katz,
I am resending the following comment letter. I originally sent it to the SEC
published address (rule-comments@sec.gov) on December 28, 1999. As of yet,
it has not been added to the appropriate list of comments page on the SEC
website (page http://www.sec.gov/rules/s72499.htm).
I am assuming this was simply an oversight, so I respectfully request that
the original letter be posted (with it's original submission date) for
consideration as soon as possible.
Thank you,
Joshua Levine
-----Original Message-----
From: joshhome
Sent: Tuesday, December 28, 1999 4:17 AM
Subject: File No. S7-24-99
I am the designer of the systems and market structures that comprise the
Island ECN. The Island ECN is an alternative trading system that currently
executes approximately 12% of all transactions in NASDAQ securities. This
letter expresses only my personal opinions and not necessarily those of the
Island ECN.
WHAT MARKET FUNCTION DO SHORT SALES PROVIDE?
By removing the requirement that a seller must own a stock in order to sell
it, the ability to sell short greatly increases the number of possible
sellers at any given moment in time. This greatly increases the chances of a
buyer quickly finding a seller at a given price.
Also, since participants are able to act on negative information concerning
a security without necessarily having to be owners of that security, the
ability to sell short greatly increases the number of potential negative
information-seekers on a given security and thus the total amount of
information available to the market for efficiently pricing a security.
Therefore, markets that permit short sales are more efficient than otherwise
equivalent markets that forbid them. Similarly, markets that facilitate
shorts sales are more efficient than otherwise equivalent markets that
restrict them.
WHY WAS THE ORIGINAL SHORT SALE RULE ENACTED?
The original short sale rule for listed securities was enacted in response
to the market crash of 1929. Some believed that the market crash was caused
by, or at least exacerbated by, unrestricted short selling of securities by
speculators. This short selling, it was claimed, caused stock prices to be
artificially depressed, which lead to increased short selling in a
self-sustaining chain reaction.
Regulators were pressured to make changes that would re-establish public
confidence in the capital markets and reassure investors that any structural
market problems had been "fixed". Short sales were an easy scapegoat. To
depression weary Americans, selling a stock you didn't own sounded a lot
like spending money you didn't have, and both sounded wholly un-American.
The short sales rules were purported to prevent an alleged manipulative
practice known as "piling on" whereby a short seller supposedly could
precipitate a stocks collapse by continuing to sell more and more of the
stock as it went down.
ARE SHORT SALE RULES EFFECTIVE?
NASDAQ SmallCap stocks continue to be freely shortable while NASDAQ NMS
stocks are now subject to short sale rules during market hours.
If short sale rules were truly necessary to prevent manipulative downside
practices, we would expect to see "pilling on" activity in SmallCap
securities when compared to their restricted NMS counterparts. There is no
evidence that this is taking place, nor is there any evidence of  "piling
 on" in NMS stocks outside of market hours when short sale rules are not in
force.
In today's world where market data is instantly available to hundreds of
millions of investors, it is impossible to imagine that any market
participant would be able to significantly manipulate the price of a
security simply by short selling it without also violating other
anti-manipulative regulations and laws.
ARE SHORT SALE RULES HARMFULL?
On a macro scale, short sale rules delay or prevent the market from
effectively discovering or reacting to negative information. This makes the
market less efficient and increases trading costs to all market
participants.
On a micro scale, short sale rules are expensive (and occasionally
impossible) to enforce, both for participants and for regulators. The futile
effort to enforce harmful and often nonsensical short sale rules diverts
resources that could be used to more effectively enforce rules that
contribute to high quality markets.
Additionally, short sale rules restrict retail investors disproportionately
relative to market professionals. Registered market makers are typically
exempted from short sale rules. Savvy professional traders typically have
access to elaborate and expensive short sale rule avoidance strategies that
effectively allow them to execute sales at times retail investors are not
able to. This visceral unfairness tends to reduce public confidence and
participation in the marketplace.
WHY DO SHORT SALE RULES ENDURE?
Unfortunately, short sale rules are very difficult to unseat since they are
strongly endorsed by stock issuers. Issuers tend to oppose any change that
could lead to increased selling pressure on their securities since that
selling pressure could result in lower stock prices. Issuers support
policies that inflate stock prices since higher stock prices reduce their
cost of capital. Also, since the policy makers in issuer companies are
typically also large shareholders themselves, those policy makers suffer
direct financial loss whenever their corporation's stock price is negatively
impacted.
Issuers as a group wield considerable political power. They pay hefty fees
to be listed on an exchange and these fees account for a substantial portion
of an exchange's revenue stream. Both the NYSE and NASDAQ are dependant on
these listing fees for their survival, making them beholden to issuer
demands. This puts the exchanges in the awkward position of supporting short
sale rules even when those rules potentially have a negative impact on
market quality.
In proposing rule 3350, the NASD sited competitive pressure from other
marketplaces as its primary motivation rather than any sort of fundamental
market need. In particular, the NASD felt that issuers were being tempted to
move from NASDAQ to the NYSE because they expected higher stock prices under
the influence of the NYSE's short sale rule.
HOW CAN THIS SITUATION BE RESOLVED?
The SEC should act to abolish short sale rules on both listed and OTC
securities.
Only the SEC is in a position to substantively change the application of
short sale rules since the SEC is uniquely empowered to mandate universal
changes across all domestic markets. This would eliminate any competitive
disadvantages a single marketplace would incur if it were to unilaterally
abolish only its own short sale rules.
I am glad to see that the SEC is thoughtfully contemplating this
controversial issue, and I am grateful for the opportunity to comment on it.
Respectfully,
Joshua Levine