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SECURITIES AND EXCHANGE COMMISSION 

ROUNDTABLE ON THE REGULATION SHO PILOT 

(Amended 9-29-06) 

Friday, September 15, 2006 

9:45 a.m. 

U. S. Securities & Exchange Commission 

100 F Street, N.W. 

Auditorium L-002 

Washington, D.C. 

PARTICIPANTS: 

SEC Commissioners: 

Chairman Cox 

Commissioner Nazareth 

Commissioner Atkins 

Commissioner Campos 

Commissioner Casey 

Diversified Reporting Services, Inc. 

(202) 467-9200 
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APPEARANCES: 

Chairman Christopher Cox 

U.S. Securities and Exchange Commission 

Charles Jones 

Professor of Finance 

Graduate School of Business 

Columbia University 

Frank Hatheway 

Chief Economist 

The Nasdaq Stock Market, Inc. 

Ingrid Werner 

Martin and Andrew Murrer Professor of Finance 

Fisher College of Business 

Ohio State University 

Paul J. Irvine 

Assistant Professor 

Terry College of Business 

University of Georgia 
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Gordon J. Alexander, 

John Spooner Chair in Investment Management 

Professor of Finance 

Carlson School of Management 

University of Minnesota 

Adam Reed 

Assistant Professor of Finance 

Keenan-Flagler Business School 

University of North Carolina at Chapel Hill 

Bob Colby, Deputy Director 

James Brigagliano, Acting Associate Director 

Division of Market Regulation 

U.S. Securities and Exchange Commission 

Chester Spatt, Chief Economist 

Amy K. Edwards, Financial Economist 

Office of Economic Analysis 

U.S. Securities and Exchange Commission 

Larry Harris 

Fred V. Keenan Chair in Finance 

USC Marshall School of Business 
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Albert "Pete" Kyle 

Charles E. Smith Professor of Finance 

Robert H. Smith School of Business 

University of Maryland 

Owen Lamont 

Professor of Finance 

Yale School of Management 

Portfolio Manager DKR Fusion 

George Sofianos 

Vice President, Equity Execution Strategies 

Goldman Sachs & Co. 

Bruce N. Lehmann 

Professor of Economics and Finance 

Graduate School of International Relations 

and Pacific Studies 

University of California at San Diego 

Richard Lindsey 

President, Bear Stearns Securities Corp. 
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C O N T E N T S 

PAGE 

SESSION ONE 6 

Opening Remarks: Chairman Christopher Cox 6 

Presentations: 

Charles Jones 13 

Frank Hatheway 26 

Ingrid Werner 34 

Paul J. Irvine 49 

Gordon J. Alexander 57 

Adam Reed 72 

SESSION TWO 88 

Opening Remarks: Bob Colby 88 

Remarks: Chester Spatt 89 

Statements: 93 

Larry Harris 97 

Pete Kyle 101 

Owen Lamont 105 

Bruce Lehmann 109 

Richard Linsey 113 

George Sofianos 113 
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S E S S I O N O N E 

CHAIRMAN COX: Good morning. Thank you all for 

being here. Welcome to our roundtable on Regulation SHO. 

That, as you know, is short for shorting. In fact, around 

here we shorten it further and simply call it Reg SHO. Even 

if that's not plain English, it has the benefit of keeping it 

short and simple. 

But one thing that we will never keep short, ever 

shortchange is economic analysis, and that's the reason we're 

having this discussion today. 

We're here to hear the considered opinion of the 

members of our two distinguished panels on what the empirical 

evidence says about price tests for short sales. 

Short selling, in general, is a topic that inspires 

many different viewpoints, but while some criticize the 

practice, arguing that it artificially depresses the price of 

securities, the Commission has never taken the view that all 

short selling is illegitimate. 

Rather, we've always recognized that short selling 

within proper bounds can have legitimate benefits, including 

facilitating liquidity, managing risk and promoting price 

efficiency. 

We've also historically recognized that abusive 

short selling can be a form of unlawful market manipulation 

and that abusive short selling can have a destabilizing 
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affect on markets. 

One way that the Commission and the Self-Regulatory 

Organizations have sought to balance these potential positive 

and negative effects is by permitting short selling and 

advancing markets while also preventing short selling at 

successively lower prices. 

When the Commission adopted Reg SHO in June 2004, 

we authorized the commencement of a pilot program to test the 

very premises of short sale price restrictions. The Reg SHO 

pilot suspends for a selected group of equities the 

provisions of Rule 10a-1(a) of the Securities Exchange Act of 

1934 and former NASD Rule 3350 that restrict the excuse price 

of short sales. 

On April 20, 2006, we extended the pilot to August 

6th of next year in order to maintain the status quo for 

price tests of pilot securities while the staff completes its 

analysis of the pilot results and the Commission conducts any 

necessary rule-making. 

Regulation is a tricky business and especially so 

in the securities area. We could take the simple approach 

and say that the foolproof way of protecting investors would 

be to make sure that they're never put at any risk, but that, 

of course, wouldn't really make for investor protection. 

That would, rather, make for investor extinction. 

The lifeblood of investing is risk, and from that 
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comes reward. The two go together and have a direct 

relationship, rising and falling in tandem. 

So no, we don't think we'll be able to invest 

riskless investing. In fact, whenever we hear that concept 

pedaled we ring up the Division of Enforcement because we 

know it's a scam. 

As with all regulation, we seek to guide ourselves 

by the central principle of the Hippocratic oath; first, do 

no harm. That's where this pilot comes in. 

Through it we seek to understand the effect of this 

particular regulation on our markets in light of market 

development since it was first adopted. The pilot 

demonstrates our commitment to base our regulatory decisions 

on sound empirical evidence. 

The evidence we've gathered from the pilot should 

help us decide whether price tests for short sales should be 

kept and perhaps even be strengthened or expanded, or, on the 

other hand, whether they should be limited or abandoned. 

And rather than just hear the sound of our own 

voices we've assembled here an illustrious team of scholars 

this morning. I want to thank each of you for your extensive 

time and energy that you've devoted to this topic and the 

time that you've taken to be here with us. It's very much 

appreciated. 

To start things off, we have Professor Charles 
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Jones of Columbia University who has investigated the effects 

that the Commission's price test restrictions on short sales 

have had on securities markets. 

Throughout his career Professor Jones has paid 

special attention to transaction costs and market frictions. 

Nor has he limited himself to the recent past. He has 

studied the history of transaction costs going back a 

century. He'll be presenting a historical paper showing how 

Rule 10a-1 affected market quality when the Commission first 

adopted this provision in the 1930s. 

Critically discussing this paper will be Dr. Frank 

Hatheway, who is chief economist at the Nasdaq stock market. 

Dr. Hatheway is a well-known researcher in market 

microstructure, and he has led several initiatives to improve 

the Nasdaq's market structure. He's a veteran of this place, 

having served as an economic fellow and senior research 

scholar at the Securities & Exchange Commission. 

This historical perspective will help frame our 

expectations for two subsequent papers which evaluate the 

price test restrictions using empirical data collected from 

the pilot program. 

The first of these two papers examining the pilot 

will be presented by Professor Ingrid Werner. Professor 

Werner is the Martin and Andrew Murrer Professor of Finance 

at Ohio State's Fisher College of Business. She has long 
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experience with securities markets, having been a visiting 

research economist at the New York Stock Exchange in 1996 and 

1997 and then a visiting academic fellow at Nasdaq in 2001 

and 2002. 

Professor Werner's paper will examine how the 

pilot; in other words, suspending price test restrictions on 

a limited number of equities, has affected short selling and 

the market quality of NYSE and Nasdaq stocks. 

These findings will then be critiqued by Professor 

Paul Irvine, Assistant Professor of Bank and Finance at the 

Terry College of Business, the University of Georgia. 

Professor Irvine's areas of interest including the behavior 

of capital markets, investment banking and market 

microstructure. 

Less than a year ago Professor Irvine authored a 

paper on short selling titled, "Liquidity and Asset Prices, 

the Case of the Short Squeeze and the Returns to the Short 

Position." 

Our last paper will also shed light on the pilot 

and what impact it may have had. This one will be presented 

by Professor Gordon Alexander, the John Spooner professor of 

Investment Management at the Carlson School of Management at 

the University of Minnesota. 

Professor Alexander formerly served the Commission 

as a visiting academic scholar. He's the author of several 
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books on investing and portfolio management. His paper on 

our pilot will be critically discussed by Professor Adam 

Reed, Assistant Professor of Finance at the Keenan-Flagler 

Business School at the University of North Carolina. 

Professor Reed's work is devoted to our business at 

hand today, since his experience comprises short selling, 

equity lending and capital markets. 

While we learn about the pilot evidence this 

morning we have another distinguished group to opine on the 

evidence this afternoon. This group consists of two former 

Commission chief economists, Dr. Richard Lindsey, who spent 

some time as director of the Commission's Division of Market 

Regulation as well before heading to Bear Stearns, and 

Professor Larry Harris, who is now comfortably back at the 

University of Southern California. 

One other panelist has experience as chief 

economist of the New York Stock Exchange, Dr. George 

Sofianos, who is now at Goldman Sachs. 

The last three panelists, Professors Pete Kyle, 

Owen Lamont and Bruce Lehmann, have built strong reputations 

as influential economic thinkers, especially in the areas 

short selling and market microstructure. 

Well, clearly there's a lot to talk about, and I 

think we put together just the group to do it. I want again 

to thank each of our participants for sharing with us your 
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expertise and for so generously donating your time to be with 

us here today. 

Our nation of investors owes you a great debt of 

gratitude for your contribution to protecting investors and 

for helping us make markets more efficient. 

Our two moderators to whom I will now turn over the 

program will be James Brigagliano, our Acting Associate 

Director of the Division of Market Regulation, and Dr. Amy 

Edwards, a financial economist for the SEC's Office of 

Economic Analysis. 

So let the show begin, pun intended. 

MR. BRIGAGLIANO: Thank you, Mr. Chairman. Just a 

quick reminder on the parameters of the pilot. The pilot 

suspended all short sale price tests from a representative 

sample of 1,000 of the Russell 3000 stocks during regular 

trading hours. 

The Commission's test for exchange-registered 

securities allows short sales on plus ticks or zero plus 

ticks based on the last sale. The bid test applicable to 

Nasdaq securities prohibit sales below the bid if the last 

bid was a down bid. 

The objective of the pilot is to allow the 

Commission's economists as well as other academics and 

members of the public to study and compare the trading of 

similar securities with and without a price test. 
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The Commission seeks evidence of the impact of 

short sale price tests on factors such as liquidity, market 

volatility, price efficiency and manipulation. Now let's 

turn it over to the economists who did the studies. 

MS. EDWARDS: Okay. As Chairman Cox mentioned, our 

first speaker will be Charles Jones. And I'd just like to 

announce to our listeners on the web cast that you can 

download the slides of the presentations today. I'm not sure 

if they're available at this moment, but they should be 

available sometime today. 

PRESENTATION BY CHARLES JONES 

MR. JONES: Thank you very much, Amy. I want to 

start out by opening the discussion by helping us understand 

the historical context by which we came to the current 

regulatory environment. 

So in particular we want to look at three discrete 

events from the 1930s, the initial prohibition of short 

sales on downticks, which happened in 1931; a 1932 

requirement that brokers get written permission to lend a 

investor's shares so that they can be shorted; and, finally, 

the 1938 strict uptick rule that was introduced by the SEC. 

So we want to look at various characteristics of 

the markets before and after these regulations changed in an 

effort to determine the effect of the regulations. I'll be 

looking at returns, volatility and also liquidity. 
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To give you a little context we need to go back and 

think about what shorting was like prior to the Great 

Depression. Shorting in the 1920s was largely unencumbered. 

It was very popular among professional traders in the U.S. 

The various markets, the lending market was very 

highly developed with very little regulatory oversight or 

restrictions. For instance, there was no uptick rule in the 

1920s. There was no formal requirement to locate shares to 

deliver before short selling. 

There were no minimum margins set by any sort of 

central government authority. There were margins set by the 

exchange or by the broker, but they were done by the 

Self-Regulatory Organization, by the exchange, by the NYSE or 

by the broker who was responsible for the account. 

For instance, near the close each day NYSE members 

would gather around what was known as the loan crowd or the 

loan post in order to borrow and lend shares for delivery 

into short sale positions, and this centralized market was 

probably a great thing. It probably reduced search costs for 

those people who were looking for shares to borrow in order 

to short sell. 

Well, of course, after the crash of 1929, things 

changed dramatically and quite quickly. We saw dramatic 

reductions in stock prices beginning in 1929 and extending 

all the way through 1932. 
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So there was huge pressure to ban short selling 

entirely. There were laws introduced in Congress. Short 

sellers were blamed very much as portfolio insurers were 

blamed for the 1987 crash. Short sellers were the scapegoat 

in 1929 and 1930. 

So for instance, in 1930, there was political 

pressure to rein in or ban shorting. Holders were urged not 

to lend their shares out to short sellers. 

In September of 1931, there was a two-day ban on 

short sales on the New York Stock Exchange when England went 

off the gold standard. And then, in October of 1931, all 

short sales were prohibited if they were below the last sale 

price. So that was our very first tick rule. 

Then there were some additional prohibitions after 

that. In 1932, the U.S. Senate released a hall of shame 

listing all of the largest short sellers in an effort to, 

sort of, shame them into not taking those short positions. 

And then finally, after 1938, after the market had 

come back for a while but after another small decline, the 

SEC imposed an uptick rule that was actually much more severe 

than the rule that's in existence now. 

Let me say a couple of words about the event in 

1932 where the NYSE changed its rules to require that 

investors give written permission to hypothecate their shares 

or to lend their shares out to a short seller. 
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Previously, any share in street name could be lent 

out, and, basically, the New York Stock Exchange tried to put 

some sand in the gears of short sellers and make it a little 

tougher for short sellers to short. 

And so, essentially, they put this rule in hoping, 

essentially, to decrease the lendable supply of shares, and, 

in fact, it did that, at least initially. One day prior to 

starting, the New York Times reported that 25 to 40 percent 

of the floating supply of stock, shares held by brokers, have 

not yet given their consent to have their shares lent. 

So what we saw there was a very short-lived 

tightening of the lendable supply market. And so what you 

see in the data is that rebate rates, the fees charged for 

borrowing shares, declined dramatically right about the 

imposition of the event, because it was very short-lived. 

If you can see this graph, this is a one-day chart. 

Essentially, these rates went very high for a little while, 

but, eventually, these high prices brought out more shares, 

and the market came back to normal and, essentially, not much 

happened there. 

Now, what that did do was this was a, sort of, 

shock to the lendable supply of shares. And what that led to 

was a decline in the short interest. So if you look right 

around the middle of the chart here, you can see that the 

blue line shows a dramatic decline in the amount of short 
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interest as soon as this rule was put into effect. 

Now, what would happen if we make the supply of 

lendable shares smaller? So if we're putting on these 

shorting restrictions, what would we expect to see? 

Well, it's not clear what we would expect to see, 

but what we did see was very little in the way of returns in 

the market. So neither the announcement day return, the 

announcement that this policy was going to be held, or the 

return on the Dow Jones around the imposition of this event, 

neither of these was statistically different from zero. 

And essentially, if you look at liquidity, there 

are also no effects of this event. So, essentially, this was 

a short-lived shock to the market that the market dealt with 

reasonably well, and there's really no evidence here against 

the rational model that says it really doesn't matter whether 

we have short sellers or not in the market. Even if we 

restrict those short sellers prices will not, in general, be 

affected, and liquidity would not be, in general, affected. 

So there is nothing from that particular event. 

Now, I think what will be of more interest to this audience 

is the events related to the ticks, the imposition of the 

tick test. 

So on October 1931, October 6th, in fact, the NYSE, 

basically, stated that all short sales on downticks were 

going to be presumptively demoralizing, and any demoralizing 
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trade had always been prohibited by the NYSE. 

Now, it's not clear what a demoralizing trade is, 

but it was -- short sales were considered -- short sales on 

downticks were to be considered demoralizing. 

So what we got on October 6, 1931, was a marking 

requirement. So short sales had to be identified as such for 

enforcement purposes. Basically, this rule was announced and 

effective the same day, and, basically, this was a very 

severe shock to the ability to take a short position. 

Because you could only sell -- you could not sell 

on a downtick at all, and, essentially, what happened here is 

that short interest fell by 16 percent, about one-sixth in 

one day. 

At this point, they were measuring short interest 

every day, so we can see exactly what happened after one day 

of this particular policy. You can see that. You can see 

those numbers there. Again, it's right in the middle of the 

chart. 

You can see the decline in short interest, but what 

also you see there is a huge rise associated with the event. 

In fact, in response to this event, stocks rose by the 

biggest one day return ever. 

Stocks rose by about 15 percent on the day that 

this policy was introduced. Now, it's not clear that 

that's -- it's not clear what the cause of that stock price 
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rise was. 

It could be that because we were restricting shorts 

what this meant that, basically, we now had optimists who 

were more likely to hold stocks, or it could be that 

everybody simply that that this was changing the psychology 

of the market, and people were going to be much more 

optimistic than before. 

What we can look at here is whether there was any 

effect on spreads or liquidity around the event, and, in 

fact, apriori it's not necessarily clear what we might expect 

to see. 

MS. EDWARDS: You can just keep going. We'll 

figure this out. 

MR. JONES: Okay. No problem. So in terms of 

spreads and liquidity, it's not clear what we might expect. 

Essentially, what we've done is we've made it more difficult 

with this rule for short sellers to demand liquidity. We, 

sort of, force them to supply it because they can't go out 

and do a short sale at the bid if the bid is below the last 

sale price. 

So we're, basically, changing the way that these 

traders have to execute their trades. Now, of course, that 

effect we have to balance out with the income effect of what 

happens to these short sellers. Do they stay in the market? 

Do they leave? Does that worsen or improve market quality in 
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general? 

And what we see, actually, is that when this rule 

was put into effect we see a decline in average spreads. So 

average spreads go from about 73 basis points down to about 

59 basis points. 

Now, part of that is due to the fact that the stock 

market increased dramatically when that rule was put into 

effect. So part of it is that liquidity and market levels 

are positively correlated. So when markets are high, markets 

tend to be liquid. So part of this effect may be the result 

of that dramatic price increase. 

When we look cross-sectionally, we see a slightly 

bigger effect in small stocks. Their liquidity improves a 

little bit more than liquidity does in large stocks. 

So to summarize the liquidity evidence based on the 

prohibition on downtick short sales, some of our other 

measures are not changing very much. There are not big 

changes in volatility or volume or our measure of price 

impact, but we do see an effect in bid/ask spreads and a 

dramatic narrowing in those bid/ask spreads, and they narrow 

most for small stocks. 

This is broadly consistent with the hypothesis that 

shorts are now supplying rather than demanding liquidity, and 

it's that artificial change in what short sellers are allowed 

to do that has this byproduct effect of, perhaps, improving 
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market liquidity. 

So we move from 1931 to 1938. And in 1938, 

February 8th, the SEC imposes a very strict uptick rule, and 

this is in response to a 35 percent market decline in 1937 

and an SEC investigation into that decline and the 

possibility of the existence of Bear raids. 

The result of that was the SEC adopted Rule 10a-1 

which required short sales in listed stocks to take place on 

strict upticks. So the short sale could only happen at a 

price that was strictly higher, at least one-eight higher 

than the last sale price. 

And, in fact, this rule was then -- it was soon 

discovered that this was very impractical for short sellers, 

because as soon as there was another trade at this higher 

price, then the short sellers couldn't trade at that price 

but had to wait for the price to go up yet another tick and 

be the first trade at that new plus tick in order to take 

their position. 

So the strict uptick rule was actually relaxed to 

the current zero plus tick rule in March of 1939. What ended 

up happening, at least in 1938, when the strict uptick rule 

was put into place, the short interest fell by about 9 

percent, so it did seem to have an impact on the number of 

shares shorted. 

And there is some evidence that people were trying 
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to hurry to beat the new rule. There are whole lot of stocks 

that were expensive to borrow just prior to the imposition of 

the new rule. 

Now, what do we see here? This is a chart that 

shows you what happened to stock prices and what happened to 

short interest around this time. And, basically, the effect 

here is about just over halfway through the chart in February 

of 1938, and you can see there is some decline in short 

interest, although there are huge variations in amount of 

short interest here. 

So in fact, it's hard to draw too strong a 

conclusion that, in fact, this was a causal event in reducing 

the amount of short interest in February of 1938. 

Now, the market for lending shares was, in fact, 

tight around this time, and what you see in the bars that are 

up high you're seeing the number of stocks on which short 

sellers actually had to pay to borrow the shares. 

The market was anticipating a certain amount 

of -- the market was, basically, trying to beat the rule, and 

there was a certain amount of demand to establish short sales 

in front of the rules. 

Now, what ended up happening here with this -- with 

the rule, basically, there's not very much in the 

announcement day returns. The stock market viewed that as, 

essentially, non-event. The market did go up on the day that 
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the rule went into effect. 

The Dow Jones, for instance, went up by 3.4 percent 

that day, which was a fairly unusual rise but not 

unprecedented. So it would have a P value of 3 percent. So 

there would be about 3 percent of days that would have bigger 

positive returns in the immediate vicinity than this 

particular day. 

Now, there is some support in that to say that, 

essentially, again, if we make it difficult for short sellers 

to short, then prices may go up and, in fact, may go up too 

high, because perhaps now we're not allowing the pessimists 

to record their views as easily as we are the optimists. 

But again, one of the main things we should be 

looking at here is what are the effects on liquidity. Again, 

apriori effects on liquidity may not be obvious, and so let 

me show you a little bit about what happened around the 

imposition of the uptick rule. 

Well, what happened around the imposition of the 

uptick rule is, again, a modest decline in spreads. So 

spreads went, essentially, from 70 basis points down to about 

63 basis points, and not too many of the other measures here 

show much of a change. 

There was a decline in volume, although we all know 

that looking at volume as a measure of the liquidity of the 

market is kind of a problematic measure to use for measuring 
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liquidity. 

And if we look at which stocks were affected the 

most, essentially, you find nothing. So what I would draw 

your attention to here on this particular chart is that there 

are no asterisks here anywhere. 

Asterisks would denote significant changes that 

would be associated with the imposition of the uptick rule, 

and you see that none of the characteristics on stocks seem 

to affect what happened to liquidity. 

So the best conclusion from the data is, 

essentially, that there was a decline in proportional 

spreads, a decline in -- an increase in liquidity, but it 

doesn't look like particular stocks were affected more than 

other stocks, and the overall effect is quite modest overall. 

So the summary here is, basically, that this 

matches the earlier evidence from 1931. Essentially, 

liquidity improves with the imposition of the uptick rule, 

and perhaps the liquidity is improving because we are forcing 

shorts to supply liquidity rather than demand it. 

So it's sort of an artificial change in the level 

of market liquidity because we are forcing shorts to, 

basically, stay on one side of the market and not demand 

liquidity. 

Now, in terms of combining these two, one can, sort 

of, think about a meta analysis of these three events. And, 
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basically, the meta analysis concludes that, essentially, 

there are positive returns associated with restricting short 

sales and definite effects on liquidity from the tick 

restrictions. 

I would caution, essentially, that it's very 

difficult to extrapolate from these earlier events to what's 

happening today. First of all, the market were very 

different. We were in the middle of the Great Depression. 

There were not a lot of alternatives for short 

selling. Essentially, now the uptick rule can, basically, be 

avoided by doing things offshore, by buying puts, but 

arranging a total return swap, but doing some other 

derivative transaction. 

Also, the minimum tick during this period was 

one-eighth, and so the uptick rule was very onerous in 1931 

and 1938. We could expect to see very substantial effects 

from it under the regime then. We'd expect much smaller 

effects today with a minimum tick of 1 cent, because that 1 

cent uptick requirement is far less onerous than 12 and a 

half cents was in the 1930s. 

So while the evidence seems to point towards some 

benefits from a -- from restrictions on short sellers, I 

would caution that those may be limited to the time period in 

which we look at. 

And again, you would caution that these are 
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conclusions drawn from single-day events in a broad market a 

long time ago. So with that, I think I will stop there. 

MS. EDWARDS: All right. Thank you, Charles. Now, 

Charles finished by telling us some of the caveats in his 

study, and it's Frank's job now to tell us about more of 

them. 

MR. HATHEWAY: Thank you very much, Amy. Before I 

really get started on the critiques I have to offer on 

Charles' paper, I think it's relevant for this audience to 

understand a little bit about my history professionally and 

personally so you know what perspectives I bring to this 

presentation. 

I am the chief economist for Nasdaq. Nasdaq 

operates under a short sale bid test, NASD Rule 3350. We 

also have a rule filing before the Commission to, 

effectively, extend the breadth of the pilot by waiving the 

bid test in approximately 75 very liquid Nasdaq stocks. 

On a personal level, I was a persistent and 

habitual short seller from 1984 to 1989, when I was a 

derivatives trader. I'm also an economist, and, presumably, 

that means I have subliminal attitudes about interfering in 

free markets. 

It's always a delight to discuss Charles' work. 

This is not the first time I've done it. He always done a 

clear and very thorough job with his presentation, so I'm 
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just going to go over some high points of his paper and then 

get right into my comments. 

We're looking at specific constraints from the 

1930s. We're going to look at the effect of these 

constraints on prices, liquidity, the stock loan market. 

What the study does not address is more normative 

questions -- could short selling be harmful in a macro 

economic sense? Could short selling be beneficial? 

Based on the answer to those two questions, should 

there be constraints on short selling? It does not consider 

what other types of short selling constraints might matter. 

In the introduction to the paper -- I encourage you 

to read the full paper, if you're interested -- these topics 

are addressed because they are left for other researchers 

some of whom are to my left. 

The question I want the audience to consider as we 

go through this paper and what's to follow, to what extent 

does market context affect how we think about short selling? 

Charles ended with those thoughts. 

1930s was short selling harmful on a macro level? 

1990s and prices, basically, also went one way but up might 

short selling constraints have been beneficial? Looking at 

data from today, the most recent decade has been one of the 

lowest volatility periods for the stock market in the last 30 

years. How might that bias what we're looking at when we 
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evaluate the pilot itself? 

The methodology for the study. It's an event 

study, what economists refer to as an event study. We look 

at three events -- the authorization of hypothecation in 

April of '32, limited strength ofy the supply of shares that 

were available to loan to short sellers. 

Downtick rule implemented by the NYSE in October 

'31 limits the ability to sell short. The SEC's uptick rule 

in February '38 also put a limitation on the ability to sell 

short. 

There are, effectively, seven variables of interest 

in the paper itself. What happened to stock prices? What 

happens to the overall level of short interest? What happens 

to the interest rate on stock loans for short sales? What's 

happened to four liquidity measures -- price impact of a 

trade, volatility, volume, spreads? 

We're going to look at whether there were 

significant changes in these variables around these three 

events. To do absolutely no justice to Charles' paper at all 

and to summarize, what, six months of work and 40 pages of 

writing onto a single chart, we have a summary of that part 

of Charles' life. 

Across the top, summarize what happened to prices. 

For the authorization hypothecation, prices went up when it 

was announced, down when it took effect. The NYC's downtick 
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rule there was a sharp price increase. The SEC's uptick rule 

no price reaction on the news, a small price increase when it 

took effect. 

Short interest in the stock loan market, which 

Charles didn't really talk about in too much detail, which 

is, sort of, regrettable, because it's really neat work that 

he did in getting that data. 

Short interest, basically, falls and falls sharply 

on the first two events. I think he brought it up for one of 

them. The stock loan market, when the supply got cut, you 

saw the chart of what happened to the price, if you will, of 

borrowing shares to sell short spiked for a short period of 

time. 

For the two events that reduced the demand for 

borrowed shares and the NYSE downtick rule it became cheaper 

to borrow shares. Demand fell. The SEC's uptick rule it 

became more expensive between announcement and 

implementation. Kind of makes sense. You know something's 

coming it's going to cut demand, you move your demand forward 

in time. 

For the four liquidity measures -- spread, volume, 

volatility, price impact -- the evidence is a little mixed. 

Charles concludes that the effect on liquidity worsened when 

hypothecation needed written authorizations and improved 

around the two downtick rules. 
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I put little asterisks by that, because I want to 

come back to that and talk a little bit about what we may 

mean by liquidity. 

Okay. To get to my caveats, the starting point is 

statistical power. How can we really tell that what we see 

in the data was unusual? Market conditions at this time was 

very, very volatile. It weakens the statistical power of the 

test. 

Charles showed you the chart with the biggest all 

time increase in the Dow Jones Industrial Average, 14 

percent, October 6, 1931. The day before was the fourth big 

biggest decline in the history of the Dow, the first 10 

percent decline since the events of October of 1929. 

It was a then record low for the Dow Jones Railroad 

Index, which became transports, and close to a record low for 

the Dow itself. 

Economists have a way to deal with these types of 

clustered periods of high volatility. We call it auto 

regressive conditional heteroskedasticity, and we're not 

going to say any more about it today. Suffice it to say it 

makes it hard to tell whether the events are abnormal or not. 

The second caveat is whether these effects persist. 

A benchmark for this might be decimalization. We went to 

penny trading five years ago. Spreads are still pretty close 

to a penny in most liquid stocks. 
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The paper talks about multiple effects to constrain 

short selling, and Charles gave a summary of those at the 

beginning. Because the data is hand-collected -- and he 

should be commended for doing that. It's a tremendous amount 

of effort -- time period, particularly for the liquidity 

measures is, by necessity, very short. 

So one of the questions to ask is, well, what 

happens in the longer term. Now, more or less the 

constraints on short selling stopped in 1938. Does that mean 

that 1938 was the right answer? Here's a chart for the Dow 

from 1931 to 1938, and I've put on there the three events 

that Charles looks at, October '31, April '32 and February 

'38. 

They each, particularly the first two, are, 

effectively, a pause in what is a falling market. The 

February '38 event is closer to what would be the bottom that 

year. 

But again the question would be to what event -- to 

what extent do these events persist? Ideally, we'd look at 

the liquidity measures, and some of the other statistics 

Charles brought out; it's very difficult to do. If we look 

at prices, we don't see anything other than a temporary 

event. 

Another issue here is identifying when the event 

took place. And when you're doing an event study, it's very, 
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very important to capture the surprise, what the market did 

not expect to happen. 

When we look at -- just to give you an example of 

how that can be important, let's look at what happened when 

the written hypothecation authorization begin. 

So the October 6th data point on Charles' 

plot -- he showed you this one for the events of April '32, 

when the NYSE tick test came in, but I'm going way over to 

the left-hand side of this chart for when the written 

authorization requirement came in. 

See the decline on the blue line? That's the 

amount of short interest in the market. It fell 400,000 

shares that day, but it had fallen over a million shares 

before that day. 

Think a little bit about how markets work. Start 

for a second -- we're in Washington. If we get -- and I live 

in Washington. If we get juicy news around here, what we do 

with it is we call the media and make sure as many people as 

possible know about it. 

In financial markets, however, you keep that 

information to yourself, and you act on it slowly for your 

own profit. I've been a member in an exchange. Exchanges 

are kind of clubby. I'd be surprised if the market didn't 

really know that something was coming, perhaps not the 

specifics. 
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Finally, the interpretation of liquidity changing 

is a bit of a challenge. Liquidity depends on perspective. 

Charles talks about substituting limit orders to market 

orders to sell short. Liquidity depends on a perspective. 

Are you a buyer or a seller? Are you aggressive or 

passive? Are you long or short? Charles' liquidity measures 

don't allow us to answer that. I'm sure he would be 

delighted to do so if he could, but, again, there are data 

limitations that are just the reality for doing work from 70 

years ago. 

Applicability of the results. Markets change. 

Have they? Have they not? Have investors and traders 

changed since the '30s? Markets have changed in many 

technical ways. I think the two that are removed in the 

second question about traders and investors, they're more 

transparent. 

They focus more on -- there's also more focus in 

the financial community on systematic risk and on controlling 

that. I don't think traders and investors are all that 

different. I was on a trading floor in October of '87. So I 

think in some sense the world has changed. In other senses 

it has not. 

Just to get to the conclusion we look at the price 

trends during the '30s we have all these additional 

restrictions on short selling as well as the ones Charles 
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addressed. Reasonable to conclude short selling constraints 

don't matter much, or, perhaps, that they do. 

One thing that I think is apparent from the data, 

market effects tend to be relatively short-lived. Markets 

adapt. They come up with new ways to do what they want to 

do. But for me to say, well, the alternative would have been 

different is, effectively, a counter-factual analysis. 

That's very difficult to do. 

We know financial markets recovered after 1938. 

What they would have done had these constraints not been put 

in we don't know. 

Finally, sometimes a short-lived effect on the 

market is what's needed, a little time out, whether we're 

talking about the British government going off the gold 

standard or some other type of financial event. Back to you, 

Amy. 

MS. EDWARDS: Thanks, Frank. At this point, we'll 

move forward almost 70 years and start studying a more recent 

time and look at what happened when we removed the rules 

again last year. Ingrid. 

MS. WERNER: It's delightful to be here to talk to 

this audience and the commissioners about Reg SHO. We are 

going to talk now about the 2005 event of getting rid of the 

short sale rule for a subset of stocks. 

And based on what Charles Jones have told us now 
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there clearly are significant differences in the market today 

compared to what we had in the '30s. We had a much smaller 

tick size. There were lots of alternatives to short selling. 

Hence, it's not obvious that we would see any 

effect at all in today's environment, but what we're going to 

do is to try to explore the effect of one part of Reg SHO. 

I guess I should highlight James Brigagliano 

already mentioned exactly what portion of the rule we're here 

to study, which is the pilot. 

And I want to take this opportunity to thank the 

Commission for providing economists with a perfect 

experiment. It's rare that we have an opportunity to 

carefully examine taking away a set of trading rules in this 

fashion. 

So we're going to look at the pilot in this work, 

which is joint work with my co-authors Karl Diether and Kuan 

Hui Lee, and what we're going to do in this study is we're 

going to take the pilot program and, as constructed by the 

SEC, we have to refine it somewhat. 

And the additional requirements that we have is 

that we are going to require a pilot stock. Those are the 

stocks again where we are not going to apply the short sale 

rules neither on the NYSE nor Nasdaq listed stocks, and we're 

only studying those two categories. We're not going to study 

AMEX listed stocks. 
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We require that stocks be members of the Russell 

3000 Index both in June in 2004 and in June of 2005. The 

reason is we don't want to have stocks that are moving in and 

out of the index during our sample. And we also are going to 

exclude stocks that have a high price or very wide spread. 

We will use the remaining stocks, those that are still 

subject to the uptick rule and Nasdaq's bid test, our bid 

price rule, as control stocks. 

We're going to do an event study just like we heard 

Charles talk about and Frank mention. The question is what 

should be the period. What we decided to do was to study a 

six-month period bracketing the event itself on May 2nd. 

However, we were concerned that we would have some 

adjustment and learning going on just around the event, hence 

we excluded from the numbers I'm going to present to you the 

little blocked area, two weeks before the change in rule and 

two weeks after the change in the rule for the purpose of our 

analysis. 

However, for those of you who are interested in 

that adjustment period there are graphs at the back of the 

paper that show you daily for every measure that we compute 

what actually happens. 

So our pre-period will be the two and a half months 

prior to the pilot date of May 2, 2005, and the post period 

that we're going to study are the two and a half months 
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afterwards. 

The screening allows us to get -- the example is 

somewhat smaller than you would expect based on Russell 3000, 

after all, supposedly having 3,000 stocks. That's because of 

our screening. But it doesn't distort the representativeness 

of the sample. That's what this simple picture shows here. 

In order to study this, we're going to look at the 

effects of the rule on market quality measures primarily, but 

our interest is also in did it actually change short selling 

activity. 

But in order to summarize short selling activity, 

we need to come up with a measure that makes sense in a 

cross-section of a large number of securities. So what we 

did, we decided that the measure that we felt most 

comfortable with was short selling as a fraction of total 

trading volume in the stock. 

So the measure which we call relss, which is 

relative short sales, is for each stock we take the number of 

shares sold short that is provided to us by the grace of the 

Commission forcing the markets to produce the data, and we 

divide that, then, by the reported short sale -- sorry, total 

volume. 

And we were originally trying to separate short 

sales from those that were subject to rules from those that 

are not subject to the rules, and that is the exempt short 
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sales. 

However, due to correspondence between the SIA and 

the SEC my understanding is that is not interpretable. So we 

are aggregating all short sales that are reported pursuant 

Reg SHO. 

We're going to look at a broad set of market 

quality measures. These are all measures to gauge the impact 

on day-to-day trading of the uptick rule and the bid test. 

Unlike Charles Jones we're not going to look at the price 

effect. We believe that will be negligible. We're not going 

to look at returns around this event. 

Simply looking at measures such as quoted spread 

and quoted depth at the bid and the ask, we're going to 

measure effective half spread, which could differ from quoted 

spreads to the extent that trades occur within the posted 

quotes. 

We're looking at order imbalances. By that we mean 

if the preponderance of orders are above the mid-point on 

average, we'd call it buy order imbalance. That's the 

definition of that measure. And we're also going to compute 

a number of different volatility measures. 

So to get us started, how would price tests 

potentially affect market quality statistics, and how do they 

affect how people trade? 

Well, the basic message here is that to comply with 
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the uptick rules, NYSE short sellers have to rely on passive 

strategies. They end up being more or less forced to be 

limit orders or liquidity providers shadowing the last sale. 

In a simple example, you can think of a market -- I 

don't have a graphical of that, but I can illustrate it where 

it's a bid of 28, 28.05 offer, market sell order that's short 

is coming in. It cannot actually hit the market bid if the 

last sale was at 28.05. It becomes a limit order at 28.05. 

Similarly, in a market, the same market, 28 bid, 

28.05 offer, last sale at 28.05, if a marketable limit order 

comes in at 28.03, it actually is not posted as 28.0. It's 

posted at 28.05. 

This is adjustments that the NYSE specialist or 

their systems have to undertake to make sure that orders are 

compliant with the uptick rule. Similar rules are applied on 

other exchanges or markets trading NYSE listed securities 

such as during this period ArcaEx, INET also during that 

period. I realize markets have changed dramatically 

recently, but this is 2005 that we're talking about. INET 

just said we will not take an order that's not going to be 

okay to be executed as a short sell order. 

So we believe that this shadowing of last sale 

produces asymmetries in the order flow and quoted depth. 

You're, basically, distorting how traders trade. If they're 

short sellers, they're going to be passive liquidity 
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providers at the ask. 

It may also have an effect on spreads and on 

volatility, a dampening effect. Short sellers are trying to 

be competitive trying to get order flow. 

By contrast, short sellers on Nasdaq, they are 

allowed to use marketable limit orders, and they can still be 

compliant with the rule. So they have a more natural mix of 

liquidity provision and liquidity demand, passive and active 

strategies; hence, we believe that there will be much less of 

an effect on market quality on that rule. That would be our 

hypothesis to start out with. 

Moreover, for Nasdaq listed stocks during the 

sample period, several market venues, including Archipelago, 

did not enforce the bid price test, which, of course, means 

it's likely to have a smaller effect on the markets. 

So let me get into talking about our results. I'm 

going to be very aggregate here, and when I talk about the 

results it's going to be just histograms, go quickly through 

it. 

But the first question you may ask, if the bid 

price test and the uptick rule restricted and made it harder 

for short sellers to trade, then, of course, we would expect 

a change or increase in short selling when you take those 

rules away. 

And here are the results for the change in short 
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sales as a proportion of trading volume. You see on the 

left-most graph the pilot and the control sample of stocks. 

And as you can see there is an increase of about -- a small 

increase, .9 percent, and it's statistically significant for 

pilot stocks. 

By contrast, during the same sample period for 

control stocks there is actually significant decline of about 

1.6 percent in short sale activity. 

The right-most column shows that both pilot and 

control stocks for Nasdaq experienced an increase in short 

sale activity. However, the increase for the pilot stocks is 

statistically significant and larger than those for control 

stocks. 

So we concluded from this it seemed at least on the 

margin that short sales, by comparing pilot and control 

stocks, we can see that there is a larger increase for pilot 

stocks. It seems that there was some small effect of the 

rule. 

The second set of hypothesis that we are going to 

test is to see -- I talked about the uptick rule, and I said 

that we would now have a more natural order flow on the NYSE 

from short sellers. 

As a result, we anticipate that quote and order 

flow asymmetries may disappear. We also believe that because 

short sellers can use more active strategies we may see a 
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marginal effect on quoted and effective spreads, that being 

that they widen. 

And finally, as a result of having less of this 

shadowing of the last sale by short sellers, we may see 

effects on short-term volatility, an increase. By 

comparison, we don't expect to see much on Nasdaq, as I 

already explained. 

I'm going to continue with my histograms here. On 

the left, we have pilot stocks. On the right, we have 

control stocks. These are NYSE asymmetries in order flow. 

What you see with the blue bar is the pre-period, and the red 

bar, which almost disappeared for the bid imbalance, is for 

the post period. 

And just visually what you see something quite 

dramatic happened for pilot stocks. Nothing much happened 

for control stocks. What is it that happened? The first 

measure is the bid imbalance. That is the proportion of 

total quoted depth in a stock on average that's on the bid 

relative to the sum of the bid and the offer. 

And you see it's negative. That means that there's 

an unusual thickness in the ask quotes. There's too little 

by about 10 percent or 11 and a half percent on the bid 

relative to the ask. 

The second measure is the buy imbalance. It says 

that, on average, about 9.5 percent of order flow in pilot 
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stocks executed above the midpoint, on average. This is the 

bias I told you about, the asymmetries we anticipated 

occurring due to the tick test. 

And as you see, they completely disappear after you 

remove the uptick rule for NYSE stocks. By contrast, on 

control stocks, you see that there is an exacerbation of the 

asymmetry over the same sample period. 

By contrast, moving to Nasdaq there's really not 

much of an effect. The asymmetries were there. There were 

some changes, but it's much, much smaller, and there is no 

significant difference between pilot and control stocks. 

What most of you perhaps are more interested in 

than these asymmetries, which I, by the way, believe are the 

first effects of the rule, is what happened to trading costs. 

And what we did, we looked at several measures. 

I'm going to produce two here, quoted spread and effective 

spread, same pattern of graphical illustration as before. 

And you notice that there is actually -- a star 

indicates significance -- a significant increase in quoted 

spreads for NYSE pilot stocks between the pre- and the post 

period by about 0.6 basis points. It's small, but it's 

statistically significant. And we also have a tiny but 

insignificant increase in effective spread. 

Now, this is the beauty of having the control 

stock. We need to see maybe all quotes widen for NYSE 
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stocks. However, that's not the case based on the experience 

for control stocks, which instead experienced a slight 

decline. 

On Nasdaq, same illustration. You see no 

significant increase. In fact, there is no change at all for 

quoted spreads. Effective spreads actually decline 

significantly for pilot stocks. However, that's the case 

also for control stocks. 

So in order to make sense of these results, we have 

to figure out relative to control stocks how was the 

experience for pilot stocks. We do that in a regression 

setting, and these are the results summarized from that. 

So what our analysis suggests is that pilot stocks 

experience a significant change in bid imbalance of about 12 

percent and buy imbalance of 10 percent. Those are big 

numbers. 

By comparison, the effect on spreads and effective 

spreads are smaller. However, the NYSE stocks experienced an 

increase in quoted spreads of .18 cents or .89 basis points, 

and the effective -- excuse me -- half spread there, so it 

should be double. To be comparable it would be .14 cents or 

.58 basis points relative to pilot stocks. But there is no 

significant change for Nasdaq pilot stocks relative to 

control stocks. 

The final thing that we examine are the effects of 
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the rule changes on volatility. Here is the quagmire. There 

are so many ways to measure volatility, and we produce a lot 

of different measures in the paper. 

I wanted just to highlight a few here illustrating, 

sort of, how it works to help you, kind of, gauge the impact. 

So the first thing is I'm going to use five-minute quote 

variances and semi-variances. 

I apologize if this graph is a little difficult to 

understand, but let's look at the left-most panel. You have 

pilot stocks. On the left-hand side, you have what happens 

to the bid. The center two columns there is what happens to 

the bid quote returns. 

You see there is a decline from the pre to the 

post. The right-most in the left panel is offers, what 

happened to the ask side of the market. Also there the 

highest bar suggests there is a decline. 

Same thing happens with control stocks. So for 

both control and pilot stock there's a reduction in 

volatility both at the bid and the offer. But the thing that 

most people have been concerned about is not volatility per 

se; it's downside volatility. 

Letting those short sellers loose will make them 

pound down on the bid and, hence, increase volatility on the 

down side. We do not see that. I have blocked in pink what 

happens to the volatility, which is just the downside 
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volatility from the bid. And, in fact, that's reduced both 

for pilot and control stocks, and the reduction is 

significant. 

We see much of the same evidence for the 

NYSE -- I'm sorry, for Nasdaq, a significant reduction for 

both sub-samples in five-minute volatility and a reduction in 

downside volatility at the bid. 

But again we have the problem of the volatility 

measures moving in the same direction, so we need additional 

analysis to conclude whether the experience of pilot stocks 

were different from that of control stocks. 

And what we do find is yes, if I measure it 

carefully, this seems to be a statistically significant 

increase, although I don't know how economically relevant it 

is in the trade-to-trade return volatility, also in our 

measures based on quotes. I measure it both on quote updates 

and 5-minute and 15-minute returns. 

The measure that's I think interesting to note is 

that in the offer quote update -- so I'm measuring every 

quote update and the returns and then calculate the 

volatility based on those quote updates -- there is actually 

an increase in the offer quote on the ask side that's 

statistically significant but not in the bid. 

So there's not more downside volatility, and the 

bid volatility per se does not change for pilot stocks 
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relative to control stocks. Again, for Nasdaq stocks there 

is no effect. 

So what do I conclude from our experiment here? 

Well, it seems clear to me that the NYSE uptick rule 

restricts short sale order strategy significantly, and the 

rule forces short sellers to use passive limit order 

strategies. 

And that is what causes these asymmetries that are 

quite stark and also on the margin depresses spreads and 

reduces volatility. 

But I highlight that this bias in favor of passive 

short sale orders and long limit sell orders it hurts some 

market participants. It hurts limit sell orders that are 

long, because -- and also especially liquidity providers as 

short sellers are trying to actually catch an uptick to 

actually get a trade. 

It also, of course, helps some market participants. 

It actually helps market buy orders to the extent that short 

sellers are more aggressive in their posting of limit orders 

than they otherwise would be. 

Of course, the bias against active short sell 

market sell orders by limit short sellers also hurt some 

market participants. It hurts limit buy orders, liquidity 

suppliers on the buy side who see their order flow coming to 

them reduced, and it helps market sell order submitters 
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because they are facing less competition. 

Now, by comparison, the Nasdaq bid price rule has a 

very limited impact on the measures that we have calculated. 

The rules already permit, when in force, the short sellers to 

use much more active strategy than the uptick rule did 

And we, as a result, see a more natural combination 

of active and passive strategies on behalf of short sellers. 

As another side note, of course, we didn't expect the effect 

to be very large given that there are market venues where you 

can trade without complying with the rule. 

So what would be my recommendation based on my 

finding -- well, based on, I should mention, other work that 

I have as well we found that short sellers on average are 

contrarian. They seem to trade on deviations of price from 

fundamentals. 

So based on that what I would say is I would 

recommend the SEC eliminates and the exchanges the uptick 

rule and the bid price rule. I feel that it unnecessarily 

distorts how short sellers trade. 

And these distortions hurt some market participants 

and helps others, and it's not clear to me that that was the 

intention of the rule itself and byproduct may discourage 

liquidity provisions. Thank you. 

MS. EDWARDS: All right. Thank you, Ingrid. Now 

discussing, I guess, how reliable some of these results are 
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and what they mean is Paul Irvine. 

MR. IRVINE: Well, it makes me nervous to sit down 

and talk to people, so I'm going to try standing. If you 

can't hear me, let me know. 

Well, a lot of people on the panel seem to be 

encouraging the Commission -- I want to thank you very much 

for inviting me today -- to get rid of the rule, to dump it. 

And I totally agree, but I came to the conclusion after 

reading this paper that not proven based on this work. 

So I'm going to try to explain why I think that 

way. This is a tree. Now, I think Ingrid has done an 

excellent job of analyzing the tree. And the tree is what 

happens in the pilot stocks when you get rid of the rule 

under normal trading conditions. 

So I'm going to talk a little bit about the 

analysis of the tree. I have no problems really with the 

methodology. As Ingrid mentioned, you rarely get such a good 

control sample and event sample, and so I think everything is 

pretty much straightforward in the methodology, and the study 

of the tree is fine. 

But you wind up with a lot of statements like the 

following: "We find a significant increase in quoted spreads 

from 2.937 to 3.042 cents." So I went and talked to a friend 

of mine who works on the buy side, and I read them that 

sentence. 
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And he said, "Do you think that's a significant 

increase in spreads?" And he gave me a strange look like 

where you been the last ten years. That spread has been all 

over the place. And I think that's what, kind of, the paper 

reads like. 

You've got a lot of these conclusions that you 

wonder about the economic significance, and I think Ingrid 

recognizes that when she talks about the next thing, which is 

the ask depth puzzle. 

I'll tell you I first found this -- this is data 

from Toronto Stock Exchange here, and it really has to 

do -- which I made a little bit bigger, but in the box you 

can see if you've got the presentation in front of you the 

ask depth is much higher than the bid depth, and this counts 

depth all the way through the book. This is total limit 

order book depth. 

I said that's an interesting puzzle. I wonder why 

that is. How come short sellers use more limit orders than 

market orders? So every time I met someone or read a paper 

that was looking at a different market like Hong Kong, 

Australia or Paris or New York I would ask them this 

question. "How come there's more -- did you find more ask 

depth as well?" 

And they all said yes, which has a lot of 

implications, as Ingrid found, for this measure of how much 
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buy activity there is, this buying order imbalance. 

So what I really like in this part of the paper is 

that this is the first explanation that makes sense and I 

totally buy it, seems to solve this puzzle. I think it's a 

big deal. 

It's a big deal to me, because I didn't know the 

answer for eight years, and I'm willing to buy this argument. 

So I really like that in the paper. 

The other thing, though, I want them to work on is, 

you know, it was really hard to tell -- and I think maybe 

we've talked to Frank a little bit about this, but I totally 

bought the arguments for what's going to happen to the ask 

depth and the buy imbalance on the New York Stock Exchange. 

And they're a little unsure in the paper what they 

want to say about the Nasdaq, whether they want to say 

whether those results should just be smaller or possibly 

reversed. 

We can talk about this a little bit more, the 

specifics in the paper, but if you look at the boxes again 

what I'd like to buy -- what I buy is that the results should 

be weaker on Nasdaq. 

So all these coefficients should have the same sign 

but not necessarily significant. Five Nasdaq coefficients 

have a different sign. I want -- challenge the paper to work 

tighter and explaining to me what's going on in the 
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Nasdaq. You can say, well, you know, nothing 

significance, doesn't really matter, but I think the paper 

could be improved if it just worked on tightening up the 

Nasdaq explanation a little bit. 

I want to encourage the paper very much to go back 

into the forest and chop down a couple more trees, because I 

thought there's at least two or three issues out there that 

are fundamentally important and really add to the impact of 

the paper. 

The first question that struck me is, kind of, who 

the heck is doing all this shorting? The paper is coming up 

with numbers like 25, 30, 35 percent of market volume is 

short sales, and I don't know who's doing it yet, and I want 

to know. 

So I asked Charles, who is an expert at all these 

things, and he said hedge funds. And I thought about this, 

and yeah, I believe it. 

But you know, if hedge funds were doing all of this 

shorting, they would have to have strategy that would close 

out, I am convinced, within the day. Otherwise, the relative 

level of short interest in the market would have risen, you 

know, much, much faster than it has. 

So you have, I think, out there a whole bunch of 

hedge funds that have these really short strategies -- short 

close, short close, short close -- wolverines on speed, or 
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something, at the trading desk. 

But it explains a lot of the cause I was getting 

the interest that hedge funds have in a lot of microstructure 

and a lot of trading strategies. 

So I bought it that there are a lot of hedge funds 

trading, but I wondered it was enough. So I went back to 

Toronto again which had at this time, and still does for that 

matter, a tick test rule on shorting. 

And I had some very interesting data that pulled 

out of the archives here. Just ignore the classifications. 

The important thing is in the two boxes and the 

classifications of traders here. 

These are client orders, so they come from regular 

order clients. It's who do they execute against. So about 

30 percent of the time those client orders are executing 

against market makers and around 25 percent of the time 

against professional trading desks and the rest of the time 

against other clients. 

So in this market, anyway, market makers are 

trading enough to explain these 30 percent short sale levels 

if they're using short sales that much. And I know there's 

people in the audience that can probably answer that question 

for us. 

But it seems to me that the optimal thing for the 

market maker to do might be instead of holding a large 
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inventory when somebody comes with a buy to sell to them, you 

know, if somebody comes to the buy, just short it, just 

borrow it. It lowers your inventory cost. 

So I would still like to know the question of who 

is doing all this shorting. 

The other thing that struck me about the paper was 

the question of volatility and particularly -- and I got the 

impression again from talking with Charles and looking at his 

paper, that the rule came in as a concern about the overall 

volatility. What effect would this tick have on the 

volatility in the market? 

So I don't think that these 5- and 15-minute 

volatility tests get to the issue for me, and that's because 

I think the real concern is what happens in periods of 

unusual volatility? What happens then? Does having the 

downtick rule exacerbate any price declines in the market? 

So I thought about that a little bit and what it 

meant, and I thought, well, what does it matter. You have 

idiosyncratic volatility. In other words, what happens when 

one stock is crashing? Is the tick test going to matter? 

Are there any costs to that in the first place? 

Well, there could be. There is this argument that 

retail traders might panic. It has been disputed in the 

literature. I've seen papers on both sides. So I guess it's 

possible that they may make sub-optimal decisions because 
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they panic. 

What about lawyers? Stock goes down you get sued. 

So there's definitely indirect costs of lawsuits from 

idiosyncratic volatility, and there has also been some recent 

work that's very interesting on some overall capital costs 

related to idiosyncratic volatility. 

So I convinced myself that yeah, it's possible that 

there are real costs from idiosyncratic volatility, and if 

the removal of this rule makes those costs higher, then we 

could care about that. 

So the first thing the paper does in its 

methodology is to drop the open. That's just when all the 

neat stuff's going on. And I understand why they did that 

methodologically, but I think in general -- and I think this 

is very doable -- what I want to know is, kind of, not what's 

going on in the uptick rule when we have normal trading 

conditions, but what about, you know, when the stock is down 

20 percent already that morning? 

Everybody is running around the floor with their 

pants on fire. I want to know what happens then? Is there 

an effect from having the rule in or out then? I think 

that's a doable thing and a testable thing and I think would 

add a lot to the paper. 

The last thing is probably not testable, thank 

goodness, but I thought I should mention systematic 
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volatility, which I always hear a lot about in Washington and 

never elsewhere. 

So I thought about -- well, like Frank, I was on 

the floor in '87, but I lived through it as well. I was on 

the trading desk of an investment bank, and the market was 

down 20 percent, and our stock was down about 55. 

And I was thinking about what would happen for 

this -- what the Commission really wants to know is this rule 

going to exacerbate, kind of, that systematic volatility? 

Could it create a problem? That's the big issue. 

And my conclusion is no. I don't think it will, 

because what's going to happen if you have no tick test? You 

can imagine the conversation between a brokerage firm and a 

specialist on that day would go something like this: 

The broker comes and says, "Well, I want to short 

this particular stock, and I don't have to worry that the 

market is down 20 percent because there is no more uptick 

rule." 

So the specialist goes, "Okay. That's fine. I'll 

let you short, but do you have a locate?" "Well, sure I got 

a locate. No problem at all." Well, maybe you do and maybe 

you don't. 

But the specialist says, "Look, this stock you want 

to short is down 40 percent, and there's no buyers anywhere." 

So the broker says, "Okay. There's no buyers, but you, 
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according to the rules, have to take the opposite side of 

that transaction." 

The specialist is going to react with, "Yeah. I'll 

get right back to you on that, but first I have to take a 

smoke break." I know you can't write a smoke break into the 

rules, but that's, essentially, what the exchange has done. 

If the market goes down 10 percent, we're all going 

to take an hour smoke break. And as I have no more time I 

think I'll go take a smoke break, too. So thank you. 

MS. EDWARDS: Thank you, Paul. Now we have a 

second pilot paper. We're going to hear from Gordon 

Alexander. 

MR. ALEXANDER: First of all, I'd like to thank the 

people at the SEC that are responsible for putting on this 

roundtable, and I'd also like to thank the people that 

invited us to come here and present our work. 

My work is joint work with a colleague who spent 

time at the SEC when I was here, Mark Peterson. Let me begin 

by talking a little bit about what Mark and I found in a 

paper that we published in 1999 about short selling. 

Actually, it involved work that we had done while 

we were here at the SEC, and we had access to order data from 

the New York Stock Exchange, which allowed us to do an 

in-depth study of short selling. 

First of all, it was rather surprising to see how 
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large a percentage of sell orders are short sell orders. As 

you can see there's roughly 23 percent of all sell orders are 

short sell orders, a surprisingly large percentage. 

The second thing we noticed is that limit orders 

constitute a large portion of those short sell orders. 

Regular sell orders limit orders are only used about 

two-thirds of the time; whereas, with short sell orders, 

limit orders are used 80 percent of the time. 

As we can see, we also found out some interesting 

things about these short sell orders and their execution. 

Short sell orders are much more likely to receive price 

improvement than a regular sell order, but there's a cost to 

that, and the cost is loss of immediacy. 

These orders don't get executed as quickly as 

regular sell orders, and we're talking about across a span of 

orders, whether it be market order, market limit, quote 

improving or at the quote limit orders. All kind of short 

orders get executed more slowly than regular sell orders. 

We also found out that short sell orders were much 

more likely to be canceled or to simply go unfilled and 

expire than regular sell orders. 

The reason for that is because of the uptick rule. 

Marketable limit orders, market short sale orders cannot 

execute at the bid. Even though the short seller might want 

them to, they can't. 
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Often, limit orders that are placed between the 

quotes cannot be executed right away. Even ones that are at 

the quote cannot be executed right away. They're all held up 

because of the uptick rule. 

This is actually consistent with what you'd call 

the ask puzzle. We found, if you looked at our table from 

our 1999 paper, it's quite clear this is what's driving the 

fact that the depth at the ask is larger than that at the 

bid. 

This is from the SEC's release about Reg SHO, about 

its stated intentions, and we intend to examine these various 

items. First of all, what we decided to do was to compare 

May with April of 2005; that is, Reg SHO became effective on 

Monday, May 2nd, so all of May is going to be our post 

period. All of April is going to be our pre-period. 

Now, there are a variety of questions you might 

ask. Isn't this too short a sample period? Don't you allow 

for some -- shouldn't you allow for some learning to take 

place? 

Well, I can tell you that we've redone everything 

using January through April as the pre-period and May through 

August as the post period, an eight-month time period. We've 

done it including all the trades, every trading day in that 

time period. 

We've excluded a week before and a week after Reg 
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SHO took effect. Everything seems to hold. It doesn't seem 

to make a difference how long a time period, whether you 

include or don't include the period right around the 

immediate start of Reg SHO. Results are quite robust. 

Now, what we did is, first of all, we insisted that 

stock must be trading every day in both months to be in our 

sample. What we're going to do is we're going to set up a 

control sample where we're going to match pilot stocks with 

non-pilot stocks. 

We're going to start off by saying, okay, we're 

going to match them by industry, two digit SIC codes, and 

also we were concerned about the presence of options, which 

turns out not to be an issue, but we didn't know that in 

advance. 

So we required every match of a pilot stock with a 

control stock not only to be in the same industry but have 

the same option status; that is, did it have listed options 

being traded or not. So that, first of all, limits our 

sample down some. 

We did this for each one of five measures, 

financial measures, which I'll get into shortly. We 

calculate -- as you can see here, we calculated a Z score, 

which, basically, matches the difference in a financial 

variable between the pilot and control, and you want to 

minimize that difference; for example, price. 
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You don't want to have a low priced stock for a 

control match with a high priced stock for a pilot even 

though they both are from the same industry and they have the 

same option status. 

So what we're going to try to do is minimize the 

difference. We can't make the prices to be exactly the same, 

but what we can do is try to make the difference between 

those two market prices as close as possible. 

We're going to do that for five different 

variables, and we're going to look at the sum of the Z 

scores; that is, the differences between the control and the 

pilot stock, and we're going to look at that sum total, and 

we're going to try to minimize -- set up our sample so that's 

minimized. 

And then, after we've done that, we're going to 

take the 50 percent stocks that have the tightest matches. 

We've also done it with the 25 percent that have the tightest 

matches. Results are exactly the same. No differences. 

The five variables that we matched on, first of 

all, price and volume, we thought those were important 

variables. 

And secondly, people who do studies of portfolio 

performance or, basically, any other kind of financial 

studies involving returns try to match stocks on three 

variables based on a study by Daniel, Grinblatt, Titman & 
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Wermers, trying to match stocks on market capitalization, 

book-to-market ratio and momentum in stock returns. 

So we match on those three dimensions also in 

addition to price and volume. And this table here shows you 

the Z scores, the composite Z score for each one of the five 

variables and the aggregate Z score. 

Basically, what this is saying is that we have a 

very good fit between our pilot and our control variables. 

For example, if you look at price, the average difference 

between the price of the control and the test sample is 

$1.33, very close when the average price is roughly $40. 

Market cap is 6.66 billion for the pilot, 6.79 for 

the control, very tight fits, basically, on average between 

our pilot and control. 

So we're going to take a subset of the 3,000 stocks 

in the Russell 3000, and we're going to do this matches, and 

we're going to end up with 226 stocks for the New York Stock 

Exchange and 183 -- 224 for NYSE, 183 for Nasdaq in our 

sample all matched on these five dimensions. 

Now, how are we going to do our analysis? Well, we 

can't simply compare pilot pre with pilot post, because there 

could be changes taking place in the marketplace, and indeed 

there were. 

Comparing April and May, we have a bear market and 

a bull market, basically, in these two months. So you can't 
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simply compare pilot pre and pilot post. 

So what we want to do is we want to compare the 

difference in the pilot over that time period on any 

particular characteristic post minus pre with what happened 

in the control post minus pre. So we're looking at a 

difference in differences is what we call it. 

It turns out it's very similar to the regression 

model that Ingrid and company were using in their paper. 

It's a little bit different. We're using a parametric and a 

non-parametric test here when we look at the difference of 

differences. 

The very first thing we decided we wanted to look 

at is we wanted to see how did the market react when news of 

this pilot study was made. What happened to the prices of 

the stocks that were going to have the uptick rule suspended? 

Did the market think that, oh, this is going to be 

bad news for these stocks, going to likely be more bear raids 

on these stocks? Is somehow or other this going to depress 

stocks because of the fear that there are going to be 

raiders, or something bad going on? 

Well, as you can see here -- and unfortunately, I 

brought my laser pointer, but it doesn't do me much good 

here. I could point at the screen and show myself what I'm 

looking at, but there isn't any screen behind me to point to. 

But if you look here, it's the right-hand column 
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that you see, the extreme right-hand column that's the key. 

That's the difference in the differences. It tells you how 

different was the change from April to May for the pilot 

stocks versus the control stocks. 

On the extreme right-hand side is for Nasdaq, the 

three columns, and then the three in the middle -- I'm sorry, 

on the left or from NYSE. 

So here the market, basically, said this 

is -- reacted with a collective yawn to the announcement of 

the pilot study. There's no reaction on the announcement 

date. There's no reaction around the time when the program 

was initiated. 

And if you look collectively April versus May 

there's no effect. It's a collective yawn. The market said 

there's nothing here that's surprising us or alarming us or 

causing us to be concerned. 

Next we looked -- a lot of what I'm going to be 

saying is -- Ingrid was mentioning before using the word 

shadow. Well, in a lot of ways, I'm going to be her shadow 

today, because what I'm going to be saying is going to be 

very consistent with everything that she said here with a 

couple of exceptions that I'll point out to you. 

And I also could say that I also feel I've heard my 

discussion already, because a lot of Paul's comments are 

applicable to me, too. 
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But here we go. First of all, we're looking at 

what happened to short trading volume? Was there any change? 

No, not on NYSE, not on Nasdaq. Was there a change in the 

number of short trades? Well, yes, there was. There was a 

notable increase in the number of short trades on New York 

Stock Exchange, nothing big going on in Nasdaq. 

Is there a change in the number of -- in the 

average short trade size? And yes, we find that the short 

trade size dropped significantly on the NYSE, no effect on 

Nasdaq. In general there's no effect anywhere with regard to 

Nasdaq throughout all of these results, which is again 

consistent with what Ingrid said. 

This made us think right away what's going on here? 

Is there order splitting going on? It is well documented 

both theoretically and empirically that large informed 

traders often try to disguise their trades by splitting them 

into smaller size orders and then having them executed. 

Now, if you were facing the uptick rule, you really 

lose immediacy. So there really is no reason to try to hide 

your trade, because you're going to get executed with a 

notable delay with your order 

But now your order on the pilot stocks can be 

executed much more quickly. So now you do want to try to 

disguise your trade, because you're going to want to take 

your large order, send it in in several smaller sizes, get 
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them executed before the market gets wind of what information 

you have that is causing you to make those trades 

So first thing we thought is this possibly the 

actions of stealth traders behind these changes? More number 

of trades, shorter trade size is going on on the NYSE. I'll 

come back to this later. 

Volatility. We looked at volatility a lot of 

different ways, some of them different from what Ingrid did, 

some of them very similar to what she did. We didn't find 

any change in volatility. 

One thing that we did do because of our setup with 

matched pilot and control stocks -- it also doesn't show 

here, but it's in the paper -- we also look at the implied 

volatility of the options on the stocks in the pilot versus 

the control sample. 

Was there a significant change in the implied 

volatility of the pilot stocks relative to the control 

stocks? We found none. We did not find a significant change 

in implied volatility. 

So no matter how we slice this -- there's three 

actually other tests that are not shown here that we looked 

at. We looked at residuals, residuals from a three-factor 

model, residuals from a capitalize pricing model, volatility 

of those residuals. We couldn't find any change in 

volatility whatever. 
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This is one place where we differ from Ingrid. But 

I guess what I would say, given that her differences were not 

economically significant, I guess is the way I would 

characterize them, it's not surprising that -- it's not 

terribly surprising that we might find something a little bit 

different here. 

Next we decided to look at some measures of market 

efficiency. Some people have said you should look at the 

auto correlation of stock returns. Is there a significant 

change in the auto correlation of stock returns? And we 

find, basically, none. 

Some people have suggested looking at upside minus 

down side R squared. That is, how closely related are stock 

returns to market returns when prices are moving up versus 

when prices are moving down? And again, no notable change. 

Again, there doesn't seem to be any change in 

market efficiency here with the pilot stocks. 

We also looked -- one other things we looked at 

were price runs, because this is something that going way 

back to the '30s I believe was a concern of the SEC about 

price runs. 

What we did here -- this is somewhat of a 

complicated table. What we did is for every short order what 

we then did is we looked and said, okay, what's the 

probability that the next order is at a price decrease? So 
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that's what P1 says, the probability of the next order being 

at a price decrease after the short order. 

And there is no difference between what happened 

with the pilot stocks versus the control stocks. So there is 

no sense that there is a short order immediately followed by 

another short sell order. Same for Nasdaq. 

Now, P2 says, okay, let's imagine you've had a 

short order followed by another sell order that price went 

down on. Is there another one where the price went down on? 

And again we see only a small evidence of a change there. 

And then P3. Okay. Let's see, what's the 

probability of having a price decrease if you've had two 

consecutive price decreases? And again there is no change 

here either. 

So there didn't appear to be any evidence that 

there's increased tendency for price runs to be taking 

plagues for the pilot stocks in May relative to those in the 

control stocks. And Nasdaq again a collective yawn. 

I'll skip over price increase results here in the 

sake of time, because they're not quite as important. 

Liquidity. We looked at quoted spreads. Similar to what 

Ingrid found we found that quoted spreads increased on the 

NYSE on the pilot stocks relative to the control stocks 

albeit by a small amount, 5.5 percent. 

And actually, it's also true whether you look at 
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quoted spreads or relative spreads where you standardize by 

price. 

Then we went and looked next at depths. And as you 

can see here we do find that there is a change in -- a 

significant change in both the bid and the ask. The bid 

is -- the depth at the bid is slightly smaller for the 

control stocks, but the ask is really 30 percent. 

It's a much greater drop relative to control 

stocks, 30 percent larger drop relative to the control stocks 

on the ask side And that's not surprising because now we 

don't have all those short orders going in at the ask backing 

up that depth that would have been happening with the uptick 

rule. 

We also looked at the bid/ask ratio, which is the 

last line here, and it's also consistent with what I just 

said, some change in the bid but a huge change in the ask. 

And again, Nasdaq, nothing going on there. 

We also looked at effective spreads, which is where 

we differ. We did find that there is a change in effective 

spreads, but it's just not statistically significant, nor is 

it economically significant. 

We have some concerns about looking at the 

effective spreads, because in order to measure effective 

spreads you need to assign trades; that is, you need to 

decide what the trade was buyer initiated or seller 
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initiated. 

And we know that most short sales with the uptick 

rule are going to be buyer initiated because of the uptick 

rule. So a measure of effective spread is somewhat 

problematic, but nevertheless we present it here. 

Panel B, the price location of short sales, is much 

more meaningful. This measure here is telling you what price 

was the short sale executed at relative to the midpoint of 

the spread? A positive number would mean it's being executed 

above the midpoint. A negative number would indicate it's 

being executed below the midpoint. 

And as you can see here, first of all, NYSE, in 

April, just like the control stocks, executing well above the 

midpoint. But then, in May, the control stocks don't change 

much, but the NYSE stocks are executed much closer to the 

midpoint. 

So you can see here short sell orders being 

executed above the bid but after the pilot being executed 

close to the bit. Nothing big going on here notably 

significant for Nasdaq. 

This just, basically, supports what I was saying. 

We see that there's a -- what's happen is there's an 

increased possibility for the pilot stocks having their short 

sale orders be executed at the bid than they were in April. 

The last line in this shows the price impact of 
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short sell orders, which is what I wanted to come back with. 

If you notice, in the last line you'll see positive numbers. 

What this is all showing is that the midpoint of the quote 

five minutes after the short sale order jumped notably in May 

relative to April. 

So there's a much bigger price impact of short 

orders in May than in April. No big deal on Nasdaq. We did 

the same analysis using a multi-variate regression equation, 

same results. 

But the bottom line on that made us think, okay, 

what's going on here is this makes us think that there is 

something going on with this order splitting by informed 

traders. 

Informed traders now have immediacy. Informed 

short traders now have immediacy. They can place their 

orders. They're disguising them perhaps by splitting them 

into smaller orders, and they're having an impact -- their 

information is getting impacted into prices much more quicker 

than it would have otherwise. 

So in conclusion, all of our results are really the 

same as what Ingrid was saying with the exception of we 

didn't find volatility increase . We did not find volatility 

changed on NYSE. Nothing seems to be going on at Nasdaq. 

This just doesn't seem to be a very effective test at all 

there. 
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We went in thinking that with the ability to use 

options and derivatives of one sort or another that really 

the uptick rule and the bid test were not very useful 

anymore, and we still continue to have that belief. And we 

would share Ingrid's recommendation that they be done with. 

Thank you. 

MS. EDWARDS: Thank you. And our last discussant 

is Adam Reed. 

MR. REED: Thanks, Amy. I'm here to discuss the 

paper "How Do Price Tests Affect Short-Selling?" The basic 

of the paper is exactly what the title says. It's to look at 

how the price tests effect short selling. 

As we've seen here, Reg SHO temporarily suspended 

the price tests for a set of pilot stocks, about 1,000 

stocks. The goal of this study is specifically to look at 

the date of the change, just a two-month period and see 

exactly how things changed right around that rule change. 

The study's design is a pure apples-to-apples 

comparison. It's a very robust study in that sense with a 

simple methodology that's robust in all sorts of 

misspecifications errors. 

Before I continue talking about the paper, though, 

I think maybe I should take a step back and ask what we 

should hope to learn from this paper and the previous paper. 

And, sort of, my framework for thinking about this 
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and for the rest of my discussion is going to be to look at 

the motivation of the SEC when it first adopted Rule 10a-1 

and the three primary motivations. 

The first motivation was to allow unrestricted 

short selling in advancing markets. Second motivation is to 

prevent shorts from driving down prices. And the third 

motivation is to prevent shorts from accelerating declining 

markets. 

So I'm going to, sort of, structure my talk around 

those three motivations and try to ask the question, first, 

is short selling easy enough to do in advancing markets? 

Second, does short selling look like it's driving down 

prices? And third, does short selling accelerate price 

declines? 

And since we are where we are at this stage in 

history, we can ask a few more questions. Is Rule 10a-1 

doing anything? Is it doing what we intended it to do or 

anything at all, and does the market respond to the price 

test being removed through the SHO pilot? 

The empirical design of this paper is very 

straightforward. The first key thing they do is match up 

every pilot stock with a matching algorithm to a control 

stock and insist that every pilot stock has a matching 

industry control and a matching option availability control. 

And then they, sort of, make a list of best matches 
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to worst matches based on five other characteristics, 

including size book to market. 

The paper makes a conservative choice. It says 

we're not going to take all matches. Unlike the previous 

paper, we're just going to take the best matches. So they 

take only about half of the SHO pilot stocks so they can be 

sure that they have good matches with all the pilot stocks 

that they do study. 

So the question, sort of, becomes which stocks are 

left out? Hard to say. We don't know much about them. And 

that's why, looking at this paper in the context of the 

Diether, Lee & Werner paper helps us to flesh out these 

results. 

But what may be left out of this particular study 

are stocks in industries that are relatively small or stocks 

in industries for option availability is spotty, because they 

would miss those two first, sort of, insistence criteria. 

The other thing this paper does is another 

conservative approach with drawbacks, of course, and that 

conservative approach is to look at exactly two months of 

data. 

The advantage here is that when you look at just 

two months of data right around the rule change you can be 

pretty safe when you say nothing else has changed about these 

stocks. It's only the effect of the rule that's making these 
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results. 

The other advantage is it avoids the Russell 3000 

reconstitution that starts in June, and that can be sort of a 

messy thing. The disadvantage is that these two months are 

not identical. 

If you look here, it's pretty clear that April 2005 

is a declining market, and May is the opposite; it's 

advancing market. But the study is smart. It has a control 

stock for every pilot stock. So simple market movements up 

and down should be washed out in the results. 

The only potential drawback is if you are willing 

to say something like advancing markets and declining markets 

affect pilot stocks differently than they affect control 

stocks. That's a possibility that we can't say much about 

here. 

On to the main results. I think the first result 

is a result about returns. They find that announcement day 

returns for the announcement of the pilot and also returns on 

the day of the pilot's implementation are no different for 

control stocks versus pilot stocks. 

Of course, they do find that cumulative returns are 

negative in April and positive in May, but that's what we'd 

expect from the, sort of, market-wide graph there. This 

return result really speaks to Motivation No. 2 of the SEC's 

Rule 10a-1. 
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Motivation 2 was are these stocks subject to bear 

raids? Overall returns aren't showing that they are. The 

returns of the pilot stocks are exactly the same as the 

returns of the control stocks. 

According to this study there is no reason to think 

that bear raids are more prominent in these SHO pilot stocks 

where short selling is unrestricted in the sense of the price 

tests. 

What about volume? Short volume. There's no 

difference in short volume on either exchange, Nasdaq or 

NYSE, but if you dig into it a little bit deeper what you see 

is that NYSE volume starts to take a different form. 

This is something that was pointed out by Gordon, 

that NYSE volume takes the form of more frequent, smaller 

trades. So trades were bundled up more frequently than they 

were -- more frequently in May than they were in April. 

Volatility, no differences in this particular 

study. Of course, that's in contrast with Diether, Lee & 

Werner. 

Overall, Motivation 1 of SEC's study was to say 

short selling unfettered in advancing markets in particular? 

The volume results here show that there's absolutely no 

difference. In terms of volume of short selling there's no 

difference between advancing markets and -- there's no 

different between pilot stocks and control stocks. 
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So the Rule 10a-1 and the removal of Rule 10a-1 

isn't changing that Motivation 1. There's no reason to fear 

short selling and upwards advancing markets is hindered by 

Rule 10a-1 or will be hindered by the removal of 10a-1. 

Next up is market efficiency. And market 

efficiency, the results here, sort of, speak to Motivation 3 

of SEC when it passed 10a-1. Auto-correlation is probably 

the strongest connection. Auto-correlation and 

upside/downside R square there's no difference in those 

measures for the pilot stocks or the control stocks. 

So that's, sort of, strong evidence that pilot 

stocks aren't more subject to shorts contributing to 

accelerating market declines than other stocks. 

Interestingly, this paper, sort of, does an unusual 

thing, and it looks at the price sequences, these five-trade 

sequences after a short order, and it finds two things. 

Gordon didn't make too much of this, but it finds 

that the second trade after a short order is more likely to 

be a price decrease for the SHO stocks, for the pilot stocks. 

It also finds that the first trade after a short is more 

likely to be an increase. 

So there's sort of a symmetric increase in price 

runs both up and both down. I'm, sort of, inclined to just 

write this off as noise, but from the SEC's or a regulatory 

perspective there's no reason to think that this is a danger 
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with the SHO stocks mostly because auto correlation doesn't 

show that these stocks are more subject to price runs. 

Furthermore, if you look at, sort of, a methodology 

like Christophe, Ferri & Angel, what you see is that when you 

see a daily price decline it's no more likely to have more 

short selling. 

Furthermore, maybe in the bigger picture, if you 

look at the returns result, what you see is that the pilot 

stocks have no lower returns than the control stocks. So 

overall I think not a cause for certain there, but there is, 

sort of, a symmetric increase in the probability of large 

run-ups in price and run-downs in price. 

The paper also gets into market microstructure 

effects. It looks at spreads, and the finds quoted spreads 

and relative spreads decrease on the NYSE and Nasdaq for 

control stocks. So that's, sort of, an unusual result. 

Pilot stocks stay the same in terms of spread, but 

control goes down. It's hard to interpret that. The one 

thing I can think of is that the pilot project revealed that 

bear raids are less likely than market makers thought. 

So market makers in the controlled stocks where the 

10a-1 protect still exist were able to relax, but I'm not 

going to put too much faith in that story. 

Depth. No change nor Nasdaq stocks. This has been 

pointed out a few times. There was an interesting change in 
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NYSE stocks, big depth decreases. But ask depth decreases 

dramatically from about 1,200 shares on average to about 900 

shares. 

This the ask depth puzzle. The authors call this a 

decrease in liquidity. I wouldn't call it a decrease in 

liquidity. I would call it a return to normal level of 

liquidity to two reasons. 

There's no reason to think that ask depth and bid 

depth should be exactly the same, but they are the same for 

the pilot stocks. Ask depth is much deeper for the control 

stocks. 

The other reason to think about this is as you 

think about short sellers they're naturally liquidity 

demanding. They've been turned into liquidity providers 

through the provisions of 10a-1. So it's more a return to 

normal as these natural liquidity demanders are turned into 

liquidity providers under the rule. 

Trade prices, basically, showed that execution is 

better for short sellers now than it was before. Overall, 

maybe an important question for this audience is can we trust 

the conclusions? 

This study is, sort of, robust, and it controls for 

two different things. It controls for differences across 

stocks but comparing each stock only to itself. It controls 

for market differences by making sure there's a good, careful 
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match for all pilot stocks 

Each one of these controls -- causes certain 

problems in terms of the methodology. The first is we're 

only getting 407 out of about 1,000 pilot stocks in this 

study, and the second is that we're only covering two months 

of data. It's possible to study 27 months of data eventually 

in the pilot program. 

Overall, looking back as, sort of, the motivations, 

we see the study is showing shorts are broken up. Depth 

decreases especially on the ask side, and execution quality 

improves for shorts. 

So yes, the market was responding to both Rule 

10a-1 and the removal of Rule 10a-1. If you look to the 

original motivations there's no evidence that shorts being 

restricted because volume's the same before and after for the 

control stocks. 

There's no evidence that shorts are being subject 

to bear raids, because returns on these pilot stocks are 

exactly the same as returns on control stocks. And there's 

no evidence that shorts accelerate market declines both in 

evidence from previous papers and evidence from auto 

correlation and R squared in this paper. 

MS. EDWARDS: Thank you. We have a few minutes for 

questions before we break for lunch, and Jamie has the first 

one. 
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MR. BRIGAGLIANO: Thank you. First, I must note 

that to the extent Amy and I ask questions we're certainly 

not expressing views of the Commission. In fact, we're not 

even expressing our own views because we're just seeking 

additional information. 

Along those lines we hope you and your colleagues 

will be commenters when the Commission issues proposals in 

the short selling arena and other arenas as well. It would 

be great to have your thoughts. 

I thought I heard Frank and Paul suggest that there 

might be some -- even if one didn't think that a price test 

was good overall there might be different considerations in 

extreme market conditions. 

There is some precedent in both SRO rules with 

circuit breakers and some Commission actions in connection 

with repurchases in which temporary rules have been put in 

place in times of extreme market stress. 

So I was wondering, first with Frank or Paul, if 

you thought there was utility for something like a circuit 

breaker short sale rule, and, if so, what parameters or 

criteria might be appropriate to trigger such a rule. 

MR. IRVINE: I think that the SEC should continue 

to concentrate -- I really like the focus on the locate rule. 

I think if you really nailed the locate rule, then you're not 

going to have a -- nobody is going to get a locate in that 
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kind of market. So if you nail that, then I don't think you 

have to worry so much. That's my comment. 

MR. HATHEWAY: The markets already have a fair 

number of provisions with how to deal with unusual events, 

some regulatory or statutory, some practical to stop trading. 

General authority has the ability to speak to any 

type of event or any type of particular type of activity that 

may be a concern at that point in time. 

Specific events -- specific authority tells you in 

advance what you need to get around, not that anyone in this 

industry would ever do that, but that's a limitation. 

MS. EDWARDS: In the three papers, it looks like 

Charles Jones' work paper was the only one that specifically 

looked at smaller versus larger stocks. I'd like to ask 

Ingrid or Gordon if they had done tests that just weren't 

reported in their papers and if they could share any of those 

results. 

MR. ALEXANDER: We're in the process of doing 

exactly that, but we don't have results ready to report at 

this time. 

MS. WERNER: I would say the same. We don't have a 

feeling for that at this point that I could report. 

MR. BRIGAGLIANO: I guess I'd like to first ask 

Ingrid I think you've done some work in the UK. Have you 

ever compared short selling in London versus in the States? 
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MS. WERNER: No, I have not. That data set is 

from -- that I worked on at the time was quite a long time 

ago, and the entire trading systems have changed dramatically 

since then in London. 

As you may suspect, how markets react to rules like 

this will depend on the market structure, so that didn't seem 

to be a reasonable comparison with my old sample. However, 

with newer data, that would certainly be interesting to look 

at. 

MS. EDWARDS: This is really a question for 

anybody, and I did notice that Adam brought this up briefly. 

But each of the pilot studies today excluded stocks that 

might be considered outliers, stocks that might have things 

that were unusual going on; for example, stocks that didn't 

make it into the 2005 Russell. 

And I just wanted to know have you thought about 

whether these extreme observations are really the interesting 

observations? For example, one can argue that the real 

benefits of the price tests come from extreme situations, you 

know, really bad news coming out about a company or it not 

making the Russell reconstitution. 

If this is so, have you really deleted the most 

interesting results from your test? 

MS. WERNER: I would, of course, agree that extreme 

events are interesting. However, when asked what the effects 
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of Reg SHO is, the pilot specifically, I think the first 

thing you have to do is look at the aggregate or the average 

results. 

And our concern is then that we would by including 

outliers be biasing or making it very difficult to see what's 

going on on average. That doesn't mean that one should not 

look at the circumstances that you mentioned. 

For instance, the rebalancing of the Russell or the 

down drift days to see if there is more short selling or high 

priced stocks, for instance, that I ended up excluding, which 

is mainly, Berkshire, Hathaways of the world that we didn't 

want in the sample. No offense, but they cause trouble for 

market microstructure analysis. 

MR. ALEXANDER: I would say that your comments seem 

to me to be in line with what Paul was saying earlier. I do 

think that kind of analysis is called for, but given what we 

had at hand, as Ingrid is saying, first step let's look at 

the ones -- in our case, using our methodology the ones that 

we could match up, and thus we did get rid of these rather 

unusual cases. But I do think that's called for. 

COMMISSIONER NAZARETH: Could I ask a question also 

or perhaps even two? I wondered you had analyzed the 

different effects of lifting the restrictions on large cap 

versus small cap or on high priced stocks or low priced 

stocks, similar to the issue that was raised earlier. 
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And also, did any of you discuss to what you 

accounted for the differences in the results between the New 

York Stock Exchange stocks and the Nasdaq stocks? 

MR. ALEXANDER: One of the things that we want to 

look at that we're in the process of looking right now is 

there is a paper that examines lendability. Adam is much 

more familiar with this literature than I am, since he's one 

of the lead people in this area. 

But there are certain stocks that are very hard to 

lend because they're hard to locate. So one of the things 

we're trying to do right now is to look at the relationship 

between various characteristics that are associated with 

lendability. 

Usually, they're small cap stocks, low volume, low 

turnover as a percentage of shares outstanding. We're trying 

to look and see if there is any differences in this group as 

a subset that's just masked because it's relatively small in 

our statistical test and doesn't come through. 

That's one thing we're trying to look at in that 

regard. As far as NYSE versus Nasdaq, I'm not quite sure 

what you meant by --

COMMISSIONER NAZARETH: Well, some of the results 

that were discussed were that the lifting of the short sale 

restrictions seem to have much less of a statistical effect 

on the Nasdaq stocks than the New York stocks, but no one 
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discussed why they thought that was the case. 

MR. ALEXANDER: Let me just mention that there is a 

working paper out there by Jim Angel, Mike Ferri and a fellow 

by the name of Christophe who have looked at the bid test on 

Nasdaq and found that it really was a very ineffective test. 

And I believe they were working at Nasdaq at the time that 

they did this study. 

And given what they did with a rather substantial 

study it's not surprising that we wouldn't find anything 

either. 

COMMISSIONER NAZARETH: Yeah. I agree. It's 

because the tests were different, and I just don't think 

anyone had gave that in their earlier presentations. But the 

tests themselves were so different that it's not -- I would 

have been surprised had the results not been as different as 

they were. Thank you. 

MS. WERNER: I completely agree. I think I was 

trying to mention that in terms of seeing how the impact 

would be expected to be of the rules. And I think the way we 

both focused on was the fact that if the rule is less 

restrictive as the bid test you allow short sellers to have a 

natural combination of active and passive strategies. 

The second thing I think is important to highlight 

is that we have a very fragmented market of trade, or at 

least we had. I think some people in this room are looking 
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for it to be more consolidated, but as a result we ended up 

with different rules applied in different parts of the 

marketplace for Nasdaq, which also makes it harder to detect 

the effect of the rule. 

We are using for Nasdaq or NYSE listed stocks short 

sales no matter where they are recorded, which I perhaps 

should have emphasized. For instance, that means that during 

our sample period roughly half of the short sales are 

reported in Nasdaq's trading systems; whereas, you know, the 

rest it reported elsewhere. 

And you all know the fraction that we're talking 

about, which, of course, means that we won't find as much for 

Nasdaq. 

MR. HATHEWAY: Can I just speak to the smaller 

issuer question? Getting ready for this panel, I called our 

issuer help desk, for lack of a better term. "Do you get 

complaints from firms in the pilot wanting to get out or 

asking what's going on?" And their answer is nobody asks. 

Three weeks ago I was in Houston and probably 

met -- at two big meetings like this with all together over 

100 issuers and raised this same question. They'll come up 

afterwards. "Do you have an issue with the pilot?" These 

are not big companies. And statistically, 1 in 6 should have 

been in the pilot. This is just anecdotal, but this is what 

I have to share. 
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MS. EDWARDS: Okay. Thank you. It's about time to 

break for lunch. We'd like to thank our authors and 

discussants again for taking the time to share their research 

and opinions here today. We'll break for lunch now and 

reconvene at 1 o'clock for the afternoon panel. 

(Whereupon, at 12:05 p.m., a luncheon recess was 

taken.) 

S E S S I O N T W O 

MR. COLBY: Welcome again all the esteemed scholars 

that have joined us today to discuss Reg SHO. The papers 

presented this morning reflect thoughtful and careful 

examination of the short sell price tests and the pilot data, 

and we really thank the authors for their efforts. 

We expect the pilot results will help assist the 

Commission in determining whether further revisions of the 

current short sale regulatory landscape are in order. 

This afternoon we ask the panelists for their 

opinions on how the Commission should use this empirical 

evidence. For example, should the Commission eliminate 

commission mandated price tests for all securities or for 

some securities? 

Are the concerns articulated by the Commission when 

it adopted Rule 10a-1; namely, prohibiting short selling from 

being used to drive down a market or accelerate a declining 

market, are these still a concern today? 
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Alternatively, should the Commission adopt a 

uniform bid test possibly extended to smaller securities for 

which there is currently no price test, or should the current 

price tests be left in place, or should they be altered away 

from large securities to smaller securities? 

We welcome the opportunity to hear from the 

panelists on these issues. Chester. 

MR. SPATT: Thanks, Bob. I thought we had a very 

interesting morning in which we heard about several studies 

exploring the consequences of pricing restrictions on short 

sales. 

We began with Charles Jones' study of the impact of 

the introduction of pricing restrictions in the 1930s. We 

then turned to a pair of interesting studies presented by 

Ingrid Werner and Gordon Alexander addressing what has 

emerged in the recent pilot or natural experiment created by 

the Commission to allow careful examination of the 

consequences of the removal of pricing restrictions on short 

sales such as the tick test on short sales. 

Of course, if traders are confronted with 

constraints on the circumstances under which they can execute 

orders when desiring to sell stocks short, they will at least 

modestly alter their order submission strategies. 

Consequently, since intermediaries who happen to be 

short rather than long at a point in time are often the 
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natural suppliers of liquidity there will be potentially 

slightly less competition on the selling side, and market 

spreads may be impacted somewhat. 

Also notice that the nature of the restriction, as 

illustrated by the tick test restriction on allowed short 

sales is potentially related itself to the prevailing tick 

size, which has changed dramatically within the last decade 

with the move from eighths to sixteenths to pennies. 

Not surprisingly, so far there is no evidence of 

material changes in short interest or retention of short 

positions as a result of the difference in the pricing 

restrictions, because the pricing restrictions don't have 

much impact on the long-term cost of retaining a short 

position as compared to the cost of the underlying collateral 

requirements. 

For example, the tick test restriction is just a 

tiny portion of the cost of retaining a short position. We 

look to this afternoon's panel for insights about the broad 

meaning of the evidence on short sales and how we should view 

this evidence. 

How do the panelists feel about the value of 

retaining pricing restrictions on short sales? In the event 

of a major market dislocation, how costly would be the 

absence of pricing restrictions? Would it be useful to 

retain these at least for less liquid stocks? 
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Should the same restriction apply across platforms? 

Should the same restrictions apply to all traders, including 

intermediaries? Finally, are there broader lessons from the 

Commission's Reg SHO pilot that can inform rule-making in 

other contexts? 

What circumstances are particularly suitable for 

informing the rule-making process by undertaking the type of 

natural or controlled experiment that the pilot illustrates? 

Also, one byproduct of the Regulation SHO process 

has been the transmission of short sale indicator reports at 

the transaction level. Should this information continue to 

be require even if the issue of short sale pricing 

restrictions is resolved? 

Now, before turning the conversation over to our 

panelists this afternoon I'd like to take a moment to thank 

them both personally and on behalf of the Commission and the 

Office of Economic Analysis and the Division of Market 

Regulation for taking the time to participate today. 

Leading academics and practitioners, they all have 

thought deeply and carefully about the nature of the 

frictions in the trading process. All began their careers as 

academics after receiving their doctorates at some of 

America's leading universities, and all have thought about 

the markets over the course of their careers. 

Larry Harris, my predecessor as the Commission's 
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chief economist, is a leading thinker about empirical market 

microstructure and trading. 

The work of Pete Kyle, who recently relocated to 

our area as a chaired professor at the University of 

Maryland, helped invent the field of market microstructure 

theory in one of the most influential academic finance papers 

in the last several decades. 

Owen Lamont is an expert is an expert on short 

selling in our markets who also brings the perspective of a 

trader and portfolio manager. 

Bruce Lehmann, one of the founders of the Journal 

of Financial Markets and the National Bureau of Economic 

Research's Market Microstructure meetings is a leading expert 

on market efficiency and trading. 

I'm pleased that Rich Lindsey, who served the 

Commission as both its chief economist and then director of 

its Division of Market Regulation and is now a senior 

executive at Bear Stearns, is able to share with us the 

benefit of his industry and regulatory experience. 

Finally, George Sofianos, who previously served as 

the New York Stock Exchange's chief economist, brings a 

sophisticated perspective about trading dynamics to bear from 

his perch at Goldman Sachs as one of the most recognized 

industry based scholars in market microstructure. 

So with those introductory remarks, we'd like the 
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panelists to, perhaps, maybe take five minutes apiece to make 

some introductory comments, and then we thought Bob and I 

would follow up with, sort of, additional questions. 

I thought we'd proceed in alphabetic order. So 

perhaps, Larry, if you wouldn't mind beginning. 

MR. HARRIS: Thank you, Chester. We saw three 

excellent papers this morning that produced, essentially, 

identical results using different methods or samples, and 

those results were that in the short-term short selling price 

tests had very -- have some short-term effects on market 

quality variables. And those variables most closely 

associated with the restrictions or with traders' responses 

to them. 

Although statistically significant, they're not 

generally economically significant. They literally just 

don't pass the intraocular impact test. They don't hit you 

between the eyes. 

Except for trade size and ask size and some trade 

frequencies that are closely related to traders' responses to 

the restrictions there's not much going on here. The facts 

that we do see represent the elimination -- or at least in my 

opinion probably represent the elimination of a distortion 

rather than a loss of a benefit. 

In particular, I'm referring to the fact that 

although the markets appear to be more liquid with the tick 
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test that liquidity is coming at some cost to the short 

sellers that were requiring them to provide liquidity. 

Generally requiring people to do something that 

they otherwise wouldn't is not attractive and comes with a 

certain cost. 

Now, I would note that as small as these effects 

are in this pilot study the size of the effects that would 

ultimately be observe if we totally eliminated the tick test 

are overestimated or overstated. 

The reason is because there are people who employ 

short selling strategies that aren't specific to individual 

stocks they will direct their order flow in the pilot period 

to only those stocks that have the -- that are unrestricted. 

So the effects that we see in the unrestricted 

stocks are liable to be overstated. If we relax the 

restriction across the board, then these short sellers would 

spread their order flow over all stocks, and we'd see even 

less of an effect. 

So overall in the short term, I don't see much 

impact of the short selling rule, these tick rules, one way 

or the other except, as I noted, restricting people from 

doing what they otherwise might want to do is problematic. 

Now, the real question that we ought to be asking 

are what are the long-run effects associated with the short 

selling rule? These rules were brought in in response to 
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concerns about bear raids, which are largely pretty 

infrequent and, as a consequence, are not likely to be easily 

identified even in the excellent study that was set up by the 

Commission. 

Long-run effects, unfortunately, as an empirical 

proposition, are, essentially, unobservable either because 

they're too subtle -- we are, apparently, just not seeing 

them in a short enough sample -- or because the effects are 

associated with very rare events such as the bear raids. 

Now, the question is how do we then deal with the 

question if the empirical evidence at the long run, which is 

really where we want to address our concerns from public 

policy, if the empirical evidence won't help us, what are we 

going to do? 

And the answer is that we have to think about 

things carefully from a theoretical point of view. The 

theory, I think, is pretty clear. 

The first effect of any restriction that makes 

short selling more expensive or difficult will be to produce 

some sort of bias hard to measure, probably impossible to 

measure that favors higher prices. 

While everybody is in favor of higher prices, I 

will note that it has some certain disadvantages that we 

should be aware of. It lowers investment returns. Lowering 

investment returns, of course, will lower total amount of 
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investment. 

It also allows corporations to waste capital that 

it otherwise wouldn't. Those are things that are not 

attractive, and those are reasons why we wouldn't favor such 

a bias. 

Now, I've saved for the last the most important 

point. We brought in the tick test because we're concerned 

about bear raids, the notion being that we wouldn't allow 

people to push stocks down that would damage the capital 

formation process, and so forth. 

But I'll note that there's another manipulative 

process about which we're also concerned, and that is the 

pump and dump. So a pump and dump is the opposite of a bear 

raid. Instead of the price being pushed down by the 

manipulator, the price is being pushed up. 

If you look at the history of enforcement actions 

at the SEC, the number of actions to deal with pump and dumps 

vastly, vastly exceeds the number associated with bear raids. 

Bear raids are very uncommon. 

That said I would note that the short sellers are 

the major allies of the SEC in the suppression of pump and 

dump manipulations, so that the short sellers in this respect 

are natural allies to the SEC in the reduction of this type 

of manipulation. 

The pump and dumps are far more common because it's 
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easier to convince people to buy stock who don't presently 

have it than it is to convince people who hold stock to sell 

their stock. 

So in a bear raid, the bear raid is only successful 

if you can convince the people who are holding their stock to 

sell it. That's a small group of people. In the pump and 

dump, all you have to do is somehow touch the hearts and 

purse strings of those people who potentially can be sold the 

story that you have to sell. 

So I think that pump and dumps are forever going to 

be more important than bear raids as a problem that plagues 

our market. The restriction of short selling hurts the 

Commission's interest in suppressing this type of 

manipulation, which is by far more important. 

So I'm, as my comments would suggest, very much in 

favor of the elimination of these price tests. 

MR. KYLE: I'm Pete Kyle, and before Larry spoke I 

told him that I was going to say all the things he didn't 

say, but he agrees very much with me on these issues, so I'm 

going to say some of the same things in slightly different 

words. 

MR. HARRIS: Probably better. 

MR. KYLE: The purpose of the CFTC I think is 

largely to protect smaller and less sophisticated investors 

from bad things that can happen to them in financial markets. 
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Did I say the SEC or the -- I meant the SEC. 

MR. COLBY: We're not going to speculate on the 

purpose of the CFTC. 

MR. KYLE: I meant to say SEC. Sorry. How many 

traders complained about being sold very high priced stocks 

in the late 1990s, and then after that lost a lot of money? 

I think huge numbers of small investors felt in retrospect 

like they got ripped off. 

They may make the mistake of thinking that they got 

ripped off because short sellers drove the prices of the 

stocks that they bought down to low levels after they bought 

them, but they would have been better off if, in fact, short 

selling had been easier and even more encouraged before they 

bought the stocks in the first place. 

So I agree with Larry that the short sellers are 

the big ally of the SEC in its efforts to protect small 

investors from schemes that would, essentially, be 

manipulative. 

Now, today we saw several papers that I would 

summarize by saying that tick tests create modest congestion 

in the market. Essentially, what a tick test is is a kind of 

very short-acting circuit breaker that prevents someone who 

wants to sell the stock short from doing so at any tick he 

wants to. 

When he's prohibited from doing it, he probably 
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leaves a resting offer in the market at the most aggressive 

price that he would be allowed to sell. And so not 

surprisingly these papers tell us that the effect of the tick 

test seems to be to narrow bid/ask spreads because of the 

congestion of offers by would be short sellers and therefore, 

apparently, to increase liquidity. 

And I say only apparently, because it's not clear 

that liquidity is actually increased if you're required to 

place these offers and not to hit bids in the market. 

What we heard less about were some other issues 

that I thought we should also discuss today, and one was 

locates, and the other is buy-ins. 

It seems to me that the locate rule is an effort to 

throw a little bit of sand into the gears that would 

otherwise smoothly allow a market for borrowing and lending 

securities to operate. 

How should this market operate? Well, the way the 

market should operate is that everybody, including retail 

investors, should see the prices at which securities can be 

borrowed, and hard-to-borrow securities would show up as 

being ones where the price of borrowing those securities to, 

essentially, rent the securities for short periods of time, 

was unusually high. 

The way it works the market for borrowing and 

lending securities is not very transparent to small 
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investors, so I think that we would be better off rather than 

requiring investors to locate securities instead not 

requiring them to locate securities but, rather, structure 

the market in such a way that it was easy to see how 

difficult it would be to borrow securities so that investors 

even without locating them at the time they make a trade can 

make a reasonable determination of what the costs of 

borrowing those securities could be after the trade is made. 

And it turns out that maybe retail investors would 

be better informed and trade with greater skill if they 

actually took this information into account. 

So I would suggest dispensing with the tick tests 

but replacing it with a system of price disclosure which not 

only disclosed information about quantities and prices being 

traded but also disclosed information about costs of 

borrowing and lending securities. 

Now, these costs are typically quite small, and one 

of the reasons may be that traders are allowed to fail on 

positions ultimately through NSCC and other clearing 

mechanisms. 

And one of the proposals that I understand is up 

for discussion is whether buy-ins should be more strictly 

enforced to eliminate short positions on which traders have 

failed. 

If you more aggressively force traders to liquidate 
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their short positions, you make it easier for someone to 

corner the market and squeeze the shorts in the stock market. 

This would have the bad effect of making the schemes that 

Larry talked about, the pump and dump schemes, easier to 

execute and would, I think, therefore, be kind of a bad idea. 

So rather than have a forced buy-in for short 

positions that have been failed on for a long period of time 

I would recommend as an alternative just a series of 

escalating modest penalties that would get the job done of, 

kind of, clearing the market for borrowing and lending. 

The way it works now is that somebody -- it may not 

trickle back to a retail investor, but somebody at the level 

of Wall Street loses interest on their money if they fail. 

So the penalty that they incur is, essentially, 

proportional to interest rates. If interest rates are very 

low, that penalty is tiny, and therefore fails would be 

relatively more attractive. 

So one way to remedy that would be to add a small 

penalty, maybe add 100 basis points, add 200 basis points, 

add 300 basis points and perhaps have an escalating series of 

penalties that would apply to all short positions in stocks 

that had lots of fails. I think that would be better than a 

buy-in by not allowing -- not really encouraging corners. 

MR. LAMONT: I'm Owen Lamont. I'm afraid I have to 

agree with the two people to my right here. I don't have 
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much disagreement with anything they said, so let me start 

first by echoing what Ingrid Werner said earlier and express 

my gratitude to the SEC for generating so much data for Reg 

SHO. 

That's part of the data used for academics. That's 

part of the role of the SEC is to improve our understanding 

of capital markets. 

I'd like to talk about two things. One is the 

price test that we've been talking about today, and the 

second is the subject that Pete Kyle just brought up, which 

is the stock lending market. 

Short sellers are very important parts of our 

capital markets. Short sellers get pessimistic information 

into prices. We don't want just the optimists to have a 

vote. We want to have pessimists also to express their view. 

So our goal in any economy is to get the prices 

right. You're not going to get the prices right if you're 

not letting everybody trade on the information they have. 

Our system in the United States right now for the 

stock market is not set up to make short selling easy. There 

are a variety of regulations one of which is the uptick rule 

or the price test we've been talking about today but other 

regulations as well that impede short selling. 

I would characterize short sellers as an oppressed 

minority. One intrument of the oppression is the regulators 
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in part, but perhaps a more important component of the 

oppression or important component of what makes short selling 

hard is the securities lending system. 

We do not have a well-functioning transparent stock 

lending system. We have a byzantine bureaucratic 

dysfunctional system, and, as Charles Jones mentioned earlier 

today, in 1929 securities lending, stock lending was done on 

the floor the NYSE. 

So in that respect, things are worse now than they 

were in 1929 in terms of the centralization of the securities 

lending market. 

Let me make a few comments about the price test 

rule, the uptick rule. I think that was an idea from the 

1930s that was always to me dubious in terms of its economic 

motivation. 

In particular, it's unclear why we would want to 

prevent or why we were worried about downward price 

manipulation but were not worried about upward price 

manipulation. So it seems an odd, sort of, asymmetrical 

rule. 

I think banning trade, which is, essentially, what 

the uptick rule does, is rarely a good idea To echo what 

Chairman Cox said earlier today in a different form, if 

you're really worried about price manipulation, then I 

suppose you could just ban all trade all together, but that, 
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obviously, wouldn't be a good idea. 

So in general, we economists like trade. We like 

unfettered trade, and I think that holds for the uptick rule. 

Now, having said that I think the price test rule is fairly 

harmless. It's a mild form of petty harassment for short 

sellers. 

It doesn't seem to be the major problem or a major 

form of harassment, so it's a harassment I could live with as 

an economist. It seems to me a far more pressing issue; that 

is, preventing prices from being right, is the dysfunctional 

nature of the securities lending market. 

So given a choice between keeping the uptick rule 

and reforming the securities lending market that's the choice 

I would take. I wouldn't expend scarce resources, scarce 

political resources, on abolishing the uptick rule, although 

I think abolishing it would be a good idea. 

Now, on the subject of the securities lending 

market one of other things the SEC has done is create the 

threshold list, which has given us a lot of information about 

stocks that are hard to locate. 

I think my concern or my view of this is the 

threshold list, the failure to deliver that Pete Kyle 

mentioned, those are symptoms, and we don't want to treat the 

symptoms. We want to treat the disease, and the disease is 

we have a dysfunctional securities lending market. 
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So to me the pressing issue for regulation would be 

to remove impediments that are causing the market to be 

dysfunctional and encourage the creation of a centralized 

securities lending market where lenders and borrows can come 

together in a transparent way with fewer frictions, with 

fewer regulations to enhance our securities market and to 

make it easier to borrow certain securities. 

One of the reasons the price test was invoked was 

price manipulation. As with Larry Harris, I am concerned 

about pump and dump. One particular type of price 

manipulation I want to mention is it appears to be legal to 

manipulate prices by manipulating the securities lending 

market. 

I can say, hey, everybody who owns stock ABC, let's 

all withdrawal our shares from the securities lending market 

and hurt those evil short sellers and cause a squeeze. It's 

unclear to me why that form of manipulation is legal where 

other forms of manipulation is not. 

MR. LEHMANN: Well, I knew I was going to be stuck 

in the middle between the smart guys and the rich guys. I'm 

not going to identify them. They know who they are. I'm the 

comic relief. I have nothing of substance to say, so I 

should say it at great length. That's what I do best. 

I also could predict what at least those two guys 

were going to say, so I had to pick which of those I would 
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echo. 

When Chester called me up and asked me to serve on 

this panel, I thought a bit about why we have regulations and 

why we have studies of regulations. I know why we have short 

sell regulations, because there are good short sellers and 

bad short sellers. 

And what the uptick rule does is it prevents bad 

short sellers from trading, or at least that's the idea. But 

that shouldn't be where I start, because everyone here, a lot 

of people know me. You know that I'll start instead with a 

story, not the substance. 

I took my daughter to a skating rink about five 

years ago, and she was having a skating lesson. And I was 

sitting with my little three-pound laptop working. Wherever 

I go with my three-pound laptop, I sell it to people who come 

by and say, "That's really nice." 

This guy comes by, and he looks at what I'm doing. 

He says, "What do you do?" "I teach at UCSD." "What do you 

teach?" "Finance." He started screaming, I mean really high 

jet decibel levels screaming about those mother loving sons 

of long lives of thieves would just knock down his stock any 

chance they got. 

And the abbreviated version of that is what happens 

when you actually talk to people who oppose the uptick rule, 

because there aren't a whole lot of people in this room who 
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think the uptick rule serves any real purpose, except there 

is one purpose. 

Because it is almost meaningless, not meaningless, 

but almost meaningless, a modest nuisance, it does give the 

appearance of doing something. I think that matters 

politically. 

In any event, when I started making noises about 

the uptick rule, it became rapidly apparent I should shut up. 

I've got time left, so maybe I should take this opportunity 

to stop now, but I'm not going to. 

Why people would ever mention the phrase "bear 

raid" in the same sentence as "tick test" is unimaginable to 

me. Even if we were talking about stock markets in Byzantium 

1,300 years ago these are wholly unrelated things. 

You may be opposed to short selling for reasons 

that have phrases like "bear raids" in them and not give a 

damn about the uptick rule. The uptick rule would be about 

the initiation of the bear raid at best or the termination of 

it. 

And it's not about optimists and pessimists. If 

you read academic papers that say, well, there are all sorts 

of voters in security markets, and some of them are 

pessimisms, and they don't get to vote when there are short 

sales restrictions, maybe that's so, but that has got nothing 

to do with the uptick rule. 
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What that has everything to do with is pump and 

dump, although I think of football when I hear that, and I 

don't know quite what it means. But I think the easiest way 

to manipulate something -- if you are a bad short seller, bad 

short sellers are people who don't intend to own the asset or 

be short the asset. They intend to go home flat with more 

money than they walked in with. 

So all you care about when you start talking about 

the uptick rule is you prevent people who go out and buy and 

buy and buy and buy, have a non-linear price impact and sell 

all at once or sell in pieces or hammer the stock a lot and 

attract people into selling with them and buy back. Do you 

do that by having an uptick rule? 

It just doesn't make sense to me that you would 

think that that would be how the uptick rule worked, because 

it just doesn't make sense to me that if it was so obvious 

you wouldn't see it when it happened, you'd treat it as part 

of a painted tape, and you wouldn't take the arbitrage out. 

Because it's an arb if it's an arb. If there is a 

zero net investment trading strategy, not an order, a 

strategy that earns money consistently, it goes away in 

markets because people are very smart in trade. 

If you trade the same way the same time every day, 

markets know that real fast. I think that Larry is right, 

that you have to sell this, sort of, theoretically not 
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because I think theory is better than empirical evidence, 

just because I have every reason to think that the good 

sellers, short sellers, stay in the pilot stocks, but the 

evil bad short sellers will take a vacation from these stocks 

while the Commission is looking. 

The Commission turns it back on, good. We'll start 

playing in that sandbox again. And the final thing is, and I 

think everybody would agree with this as well, that penny 

ticks are not effective ticks. 

If you really want to have an effective tick rule, 

a half a dollar ought to work, maybe a buck. That's not such 

a joke, because it's not so long ago that spreads were that 

high in fixed income markets, which brings me to my last 

point, which brings me to my last point. 

It's off topic, but I wish the Commission would 

start paying a lot of attention to markets that don't work 

well. The equity markets are far from perfect, but they're 

pretty damned efficient. 

We can all think about fixed income markets that 

have gotten better in the recent past with very small changes 

in market structure that make -- create large improvements in 

transparency. Transparency ought to be what all markets are 

about. 

MR. LINDSEY: I'm Rich Lindsey. I have to agree 

with Bruce. I've personally been shocked at how much 
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academics are getting paid nowadays also since I left 

academia. 

I can also answer one of his questions which are, 

you know, what's the purpose of laws or regulations, and 

that's clearly to impose some type of social convention or 

morays on the way people behave or act. 

Now, I live in New York City, so there are lots of 

social conventions imposed upon us by laws. I'm going to 

talk about a few of my favorite ones. 

For instance, in New York City, it's illegal or 

you're required when you're riding in an elevator that you 

must not talk to anyone. You must hold your hands in your 

lap and look at the door, and everybody in New York does 

that. 

There's also a provision on the books that says 

that citizens in New York City cannot greet each other by 

putting their thumb to their nose and wiggling their fingers. 

Now, I think that's probably a very good social convention. 

It would be rather distracting if everybody on the street 

were doing that. There's also a $25 fine that can be levied 

for flirting. 

So these things kind of go right in hand, I think, 

with the uptick rule. It's an old law that's on the books. 

The markets from the '30s are probably not the markets that 

there are today. I think almost everything that has been 
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said or can be said has been said. 

That doesn't mean that we won't all throw in our 

two cents. Another way of looking at it is if you take 12 

financial economists and put them up here and ask them what 

they think of the uptick rule, they're all going to agree 

because it's just an inhibition on the market. I'm 

presupposing George here, but I have a feeling he's going to 

join the club. 

The real question in some ways with the uptick rule 

is who is it that we're preventing from being able to short? 

There was a very good question that was asked early today. 

Who are all of these short sellers? 

If we're looking at 30 percent, if that's the 

number, of the activity being shorts, that's a pretty good 

question. Where is all the short selling activity coming 

from? Because clearly it can't be 30 percent every day 

cumulative or somehow we run out of the stock fairly quickly. 

So who do we prevent from shorting? Well, I can 

tell you that we're not preventing any of the professionals 

from shorting by the uptick rule. 

Either by virtue of the fact that we have a penny 

or sometimes sub-penny tick in a market that's not much of an 

inhibition. I agree with Owen that's, kind of, a petty 

harassment associated with what anybody who want to 

short -- any professional who wants to short can do. 
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At the same time, the markets today are so 

connected and so electronically available, at least to any 

professional, that you can probably find a market someplace 

where you're not on a -- where you don't have to worry about 

the tick rule one way or another. 

And beyond that there are ways to construct 

derivative or swap instruments that, essentially, take it out 

of the realm of you even having to worry about it or care 

about it. 

So from that standpoint, it's not clear that 

we're -- I found it slightly amusing when somebody said, 

"Well, who are all the shorts?" The answer was hedge funds. 

Well, anything that's magical and we don't know what's 

happening, it must be the hedge funds that's doing it. 

For sure they're not the ones particularly worried 

about it, because they've got lots of other ways to achieve 

and put on those short positions without worrying about the 

rule other than minor harassment. 

So then it comes down to the question of who are we 

trying to prevent from going short? And does preventing, the 

what I'll call, basically, the retail investor from easily 

shorting, does that somehow stop market prices from going 

down, or does that stop and create some type of ability to 

prevent bear raids? 

I don't even really know what a bear raid is 
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anymore. I think that market manipulation was something out 

of our long ago past, and we all know that market 

manipulation today is probably illegal and much easier to 

find than it would have been in the '30s. So we probably 

don't need to prevent bear raids. 

It's really a matter of the asymmetry in the 

market, and it's not an asymmetry from the professional side. 

It's really an asymmetry as to how we're letting individual 

actors behave in those markets and whether or not we're 

having a level playing field from that standpoint. 

MR. SOFIANOS: George Sofianos. I was getting 

progressively more sad and more sad going through this 

discussion here. And I kept thinking poor uptick rule. I 

mean, it has been with us for 70 years now. Anybody to stand 

up in defense of the uptick rule? 

Well, it's not going to be me. Of course, the 

other challenge I have I'm the last here, and so how can I 

make it different and interesting. 

What I thought I'd do is, sort of, take a more 

general tack, because some of the issues we're addressing 

here I think are more general issues in the context of 

rule-making. 

I'd like to begin by first congratulating the SEC 

on the approach they have taken for the Reg SHO tick test, a 

well-design experiment, and I would definitely like to see 
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more of this in our rule-making going forward. 

Cost benefit analysis, of course, is the way to go, 

but cost benefit analysis based on empirical research. The 

Reg SHO experiment is a good example of how it should be 

done, try to quantify as much as possible the tradeoffs, 

including the cost of implementing the regulation itself, and 

I'm going to come back to this in a second, my practitioner 

perspective on that. We tend to underestimate the actual 

cost of implementing rules. 

I would also like to congratulate the researchers. 

They did a great job, high quality empirical research and 

also make a plea for more applied research of this kind, sort 

of very, sort of, down to earth applied questions, try to 

find the answer. 

Let me make some general comments. The empirical 

research approach in the context of rule-making raises the 

important question how to evaluate the empirical evidence. 

My view is the burden of proof in the case of regulation to 

regularity should be very high, not marginal benefits. 

Substantial benefits are needed to justify a 

regulation, and here is my sound byte. I want the need to 

scream, not to whisper. All I've been hearing today is 

whispers, kind of marginal benefits here and there, kind of, 

maybe significant. I don't know. 

And it, kind of, makes it easier, actually, sort 
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of, to evaluate the empirical evidence. If it's not, sort 

of, screaming at you from the data, then you shouldn't 

bother. 

And the reason here is, of course, the cost of 

regulation. Again, I'm going to recap here as most of the 

people before me touched on this. Because of regulation the 

monitoring and enforcement costs can be very high, especially 

since all these rules inevitably come with exemptions, the 

need for exemptions that complicates the rules and make the 

enforcement much harder. 

I'm not arguing against exemptions. I think the 

exemptions are needed. It's just that there is an 

alternative approach, kind of, go for the simplicity, and 

unless the need screams do not impose the rule. 

And then of course there are the inevitable 

attempts to get around the rules, and a lot of ingenuity is 

wasted on this because of the nature of our markets. Then 

there are the jurisdiction issues. We touched on this, the 

derivatives trading and regulated arbitrage by synthetically 

creating what we're not allowed to do in the underlying. 

In the dynamic environment, rules quickly become 

stale. Again, the tick test itself is a good example of 

this. The switch to pennies dramatically reduced the impact 

of the rule. 

These are not necessarily reasons against the rule. 
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They just raise the burden of proof because of regulations 

that need to be taken into account and how to assess the 

empirical he had. They need to scream, not to whisper. 

There's a tendency to severely underestimate the 

cost of implementing a new rule. I'll give my favorite 

example of this, and this is a rule I like, by the way, and I 

think we should see more of this. This is the famous Dash 5 

rule, Rule 605. 

It so happened that when I joined Goldman that was 

the first project I was assigned, to implement the rule. It 

was an interesting experience, because we spent probably at 

least a year, weekly meetings 12 of us trying to implement. 

It wasn't to circumvent the rule, or anything, just 

to get it right and do the right thing the way, sort of, the 

rules requires. Because markets change, our systems change 

it is a very expensive rule, but on balance I do think that 

particular rule justifies the cost 

Quickly some comments specific to Reg SHO. Again, 

we've touched on this, a fundamental problem with restricting 

short selling. There is good and bad short selling. 

Momentum short selling can be destabilizing. 

Unfortunately, we cannot distinguish, so we 

handicap the good with the bad, washes out and we're left 

with the dead weight cost of regulation. 

Another important point that needs to be 
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reemphasized the short sellers are already handicapped, a lot 

of restrictions. I do think these restrictions already do 

most of the job. 

So quickly my recommendations. Based on the 

evidence I'd get rid of the tick test definitely on the large 

cap and midcap stocks. Again, it was touched in the earlier 

panel there is little evidence about the small cap stocks at 

this point. 

But whatever is decided cross-market uniformity is 

crucial. Again, we touched on this panel, continuous 

focusing on the lending market and enforcement of locate and 

delivery rules. 

Continue marking I think the short sales, the 

marking of the short sales should be retained. I think we at 

Goldman at least we need it for internal purposes anyway, so 

I don't think that's an extra cost. 

Should exchanges continue reporting Reg SHO pilot 

data? I have no strong view on this, and I'm not very sure 

of the cost. But at least in the short order I think the 

answer should be yes. It would just give the academics more 

data, so we can get more interesting research. Thanks. 

MR. COLBY: Well, I was under the impression we 

were going to talk about in the roundtable in the Reg SHO 

pilot, and we started off from debating whether bear raids 

were as bad as pump and dumps all the way down to the 
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existence of the market regulation program. So it has been 

enlightening. 

I feel a little bit like a person of faith facing 

the lions and debating whether the ethics of eating someone 

that's there to be eaten. 

If you don't mind, I'd like to go back to some of 

the questions about the pilot, if that's okay. The first 

would be is there reason to believe that the pilot is 

representative of what trading would be like if the rule were 

applied across the market? 

I think Bruce said that maybe the bad short sellers 

might not -- they may have behaved during this period. I 

look at my son, and while I'm watching whether he should be 

allowed to drive the car, he drives very well. I'm not sure 

if I weren't watching he'd drive as well. 

Is it a pilot experience that you think is 

representative of what conduct would be like in all stocks 

once the decision had been made about whether there should be 

an uptick rule or not? 

MR. HARRIS: Can I respond to that? I think the 

pilot demonstrates very conclusively and very clearly that if 

the tick rules were drop that, essentially there would be no 

difference in the markets that you would be able to identify. 

There would be slight changes in liquidity, as 

we've seen, but it wouldn't be an issue. As I noted in my 
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discussion, if anything, the results of the pilot probably 

overestimate what effect it would have. 

I just don't see any -- I think it's very 

successful in that respect and will demonstrate that there's 

not much regulatory risk of dropping it, at least from all 

processes except for political processes. 

MR. LINDSEY: I mostly agree with Larry. I think 

the only place where there is real question is in much less 

liquid stocks than were included in the pilot. I think it's 

much harder to tell. Those, of course, generically are also 

the stocks that Larry was talking about so much earlier when 

he was talking about pump and dump type of schemes. 

You're not seeing that in very liquid stocks 

generally. It's going to be in stocks that most of us have 

never heard of. So that would be, I think, an issue open for 

additional study or additional dialogue. 

MR. SOFIANOS: And there may be also a practical 

way out of the dilemma. You can, sort of, gradually phase 

out the rule, sort of, gradually expanded list of stocks that 

are not subject to the tick test and, of course, always 

reserve the right, if something turns out wrong to go back. 

MR. LEHMANN: I'm now in the middle so I can talk 

again. I actually think the study was incredibly well 

designed. The experiment is a really, really good one. I 

agree that the tick test should be dropped. 
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I don't agree that I know from evidence, not have a 

belief from prior beliefs what the world with look like post 

the death of the uptick rule, because I think that if you 

think about the kind of experiments that we can run and the 

things we can measure we measure what happens to trades and 

venues. We don't measure what happens to trading strategies 

and venues. 

So it may well be that there are all sorts of zero 

net supply traders, folks who go flat every day that are 

there or that are not there that do cause problems and do not 

cause problems. 

I really don't think that there are a lot of people 

out there who can do arb strategies within the day and go 

home flat all the time. I may be wrong, but I don't think 

that. 

I don't think that the Commission study, which 

raises the bar considerably for the quality of work done in 

support or in contradiction to regulation, I don't think that 

you can remove that last bit of regulatory risk. 

You have to ask yourself what do you think you know 

about markets? What do you think he know about players in 

the markets? Where have you seen things like this that 

happened that were bad things and then try to decide if you 

think George is actually doing them, because it's George 

you're afraid of. 
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It's not some guy -- and George is not doing this 

stuff. I'm not even coming close to intimating that. The 

last thing, George reminded me of something. Dash 5 is 

another good piece of regulation, but it's again one that you 

can't interpret unambiguously. 

You can't tell if the high cost venues are better 

or worse than the low cost venues, because maybe the hard 

trades are done in the high cost venues, and the easy trades 

are done in the low cost venues. 

You always have this problem of interpreting these 

experiments. They're not ones run by physicists under 

controlled conditions. 

MR. KYLE: I have a quick comment. I think that 

the experiment that has been done is convincing for normal 

market conditions, but where it probably matters the most is 

in situations where the market is crashing. 

To take a day where stock prices are down 10 or 15 

percent. What would happen then? And essentially, what the 

tick tests do is require the sell orders to accumulate and be 

a, kind of, overhang on the market rather than be executed 

immediately. 

In a crash situation where there might be a lot of 

people selling some of whom are short already and some of 

whom aren't, it's a circuit breaker question. So I want to, 

kind of, reiterate what I said earlier, that the tick test is 
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a, kind of, back door way of doing circuit breakers, but 

where it really matters, which is in a crash situation, it's 

your real circuit breakers that matter. 

And I don't see any reason why in a situation where 

circuit breakers are going to be invoked you would want to 

apply those circuit breakers differently to someone who's 

shorting compared with someone, say, like a portfolio insurer 

who is dumping a large portfolio of stock that they already 

own. 

Nor do I think it matters whether they would have 

to borrow the stock to complete the stock or whether they 

wouldn't have to borrow the stock to complete the 

transaction. There are, kind of, two definitions of being 

short. 

One is do you need to borrow the stock to complete 

the transaction? The other is are you a person who is happy 

when the price goes down based on the positions you hold in 

all the different securities you invest in? 

I don't see why the answers to either one of those 

questions should have a big effect on circuit breakers 

operating in, sort of, a panic scenario. But I think it's a 

circuit breaker question and not a tick test question. 

MR. SPATT: I'd like to ask a follow-up question. 

Clearly, all the panelists suggest getting rid of the pricing 

restrictions with the possible exception of the smallest 
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stocks. 

And I guess I'd like to get a little bit more 

understanding of what folks think with respect to smaller 

stocks. Do folks think that the Commission should retain 

pricing restrictions with respect to the smaller stocks? And 

if so, how small is small? 

MR. COLBY: Could I point out that the really small 

stocks have none now. There's a strange illogic to it. 

MR. SPATT: Here is the stocks for the Russell 3000 

stocks. 

MR. LINDSEY: Right. I just want to be clear. I 

said that there was no evidence in the research that said 

that. 

MR. SPATT: Right. 

MR. HARRIS: I was just going to say the same that 

Bob said, that the smallest stocks right now aren't subject 

to the tick test, and you don't see a lot of people clamoring 

for it. Of course, those are the ones that are most subject 

to the pump and dump. You can only imagine how much worse it 

would be if people were restricted from trading against 

those. 

I think it's really worthwhile to say in the 

simplest terms possible just how difficult the pump and dump 

problem is. In the last month, I've noticed, and I'm sure 

everybody else has, that spammers have figure out how to get 
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through the spam filters. 

My e-mail reader is just buried in notes saying 

that I should buy this, that or the next thing. It's always 

buy this. None of it is you should sell that. It's always 

buy this, that or the next thing. 

And I look to the price and volume charts for these 

starts, and I think, well, gee, I mean, you can tell the 

stuff is spam. You can even see the tricks that the spammers 

are using to get it through the filter, which, basically, 

says it's spam. 

And yet the price and volume charts show that 

prices are rising, and volumes are rising with the arrival of 

these literally tens and fifty e-mails per day that I'm 

getting, and I'm sure many of you are as well. 

So what does it say? It says that there are people 

out there who read this and allow their 

imagination -- something about the story catches their 

imagination. They go out and trade the stock. 

Now, I haven't read them that closely, but I'm sure 

they all have disclaimers that they, you know, it's just an 

opinion, and so forth. And even if they didn't, it wouldn't 

matter because it's coming from Eastern Europe or someplace. 

So what can the Commission do about this? 

Somebody is expressing an opinion, or they're 

expressing an opinion that's out of the jurisdiction of the 
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United States. You, of course, know that there is a dealer 

who is benefiting from it, but you can't draw a line to the 

dealer. There's, essentially, not much that the Commission 

can do, although I'm sure they're concerned about it. 

What can short seller do? A short seller can look 

at it and say, gee, this is going to go up, and it's going to 

go down, and I can make some money here. 

So the short seller steps in and issues his short 

sale orders and at least keeps it from rising as much as it 

otherwise would, which, of course, protects those folks who 

foolishly thought that they should buy on something that came 

into their e-mail reader. 

Now, the tick restriction affects those short 

sellers only on the way up -- I'm sorry, only on the way 

down. So they, of course, can sell into it as it's rising, 

but it prevents them from continuing to profit as they're 

pushing it back to where it belongs. And that's a problem. 

But for these particular stocks, they may not be 

subject to tick restrictions. The bigger problem is the one 

that Pete mentioned, which is trying to understand the 

settlement market. 

Usually, these stocks can't easily be borrowed. 

And so the question is how do you resist the pump and dumps 

in a situation where you're not allowing naked sales, short 

sales, and there is still a serious problem. 
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And the answer can only be that we have to publish 

the rebate rates or, essentially, publish the prices in the 

loan market so that people can at least see that there's 

something unusual happening. 

Once the longs see that there is something unusual 

happening they might sell into it and thereby hurt the 

manipulator, or other people who are contemplating long 

positions might see it and say this is just foolish, because, 

obviously, it's over-priced. 

MR. LEHMANN: I was almost going to say nothing, 

not in substance, nothing, because Larry said most of what I 

was going to say. I just wanted to add a couple of things. 

One is I'm absolutely amazed as how much money is 

waiting for me in Nigeria. I can't wait to go there. I do 

think it's kind of strange to talk about pump and dump in 

little stocks, because the pump here involves getting through 

spam filters, and the dump here really involves selling. It 

doesn't really involve shorting. 

The uptick rule has a whole lot to do with blowing 

through the nonexistent liquidity in small cap stock by 

finding a lot of widows and orphans who all of a sudden want 

to buy it because they got something from Outlook. 

And I do think always the first best answer to 

anything is transparency. In a transparent lending market, 

we get rid of a lot of the things that even retail guys would 
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be confused by. I don't think George is confused with our 

lending market, but I think there are lots of people who are, 

and it can't be bad to have transparency in that market. 

MR. COLBY: Larry, I always thought that the major 

impediment to shorting in a small stock pump and dump is that 

the market was so controlled by the firms that were doing the 

pushing that you could get burned and squeezed on the way up 

to be able to be taken way past your pricing power. 

And so the risk was just too high -- if you don't 

know where the top of that market was, the risk of getting in 

was so high that they could outlast you and take you to 

places, and you'd just be burned out, so it wasn't a safe 

place to short. 

MR. HARRIS: The danger there is not that you could 

get taken past your tolerance. You can spread that risk 

around. Most of these situations are so well recognized that 

people would be willing to spread it around. 

The real danger is a short squeeze. They'll push 

the stock up and then manage to pull it back from you. And 

this is why the settlement issues are so important. 

MR. KYLE: I was going to say the same thing as 

Larry. The big threat there is a buy-in. If it's a penny 

stock or really tiny stock, a large hedge fund would short 

100 percent of the float in that stock to stop a manipulation 

that was a, kind of, pump and dump manipulation. 
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But if they were going to be threatened with a 

buy-in on their 100 percent of the flow, that would eliminate 

their ability to protect the small investors from exorbitant 

prices. Hence, it's necessary, I think, for the fails to be 

remedied with a, kind of, gentle punishment, if you will, 

rather than a draconian one of a buy-in. 

MR. LAMONT: I think the situation is maybe worse 

than you guys are characterizing it, because for many of 

these the spam that you get is not about legitimate stocks on 

the New York Stock Exchange. It's about penny stocks, pink 

sheet stocks, and many of those you simply cannot short them. 

There is no market, so transparency is not -- you 

can transparently publish zero short interest, zero rebate 

rate. Nothing is happening there because the lending market 

is dysfunctional. 

It's not that people are afraid to short. For 

certain stocks, they literally cannot short. You call up 

your broker, and it is not a doable transaction. 

MR. KYLE: You're saying it's not doable because 

you can't locate the stocks? 

MR. LAMONT: Yes. 

MR. KYLE: So if you eliminated the requirement 

that you locate the stock and just allow somebody to short it 

with the intent of failing and fail for some period of time 

with a modest punishment of maybe an extra couple hundred 
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basis points in fees per year, that would enable you to stop 

a pump and dump. 

It's attractive to pump and dump those stocks 

precisely because the potential shorters can't do that. 

MR. LAMONT: I'm not ready to endorse your 

particular solution, but I think the problem is the 

securities lending market, and that's the problem with the 

pump and dump. 

MR. COLBY: I suspect -- we're way off topic here. 

I suspect there's a bigger problem than that. Unless you're 

extremely highly capitalized, if I was Rich or George, I 

wouldn't extend the margin for this for several reasons. 

One, because you could get caught in a short squeeze -- I 

shouldn't speak -- and also, some of these firms don't 

survive. 

If you survive in taking down that pump and dump, 

you may take out the firm and break all your trades. I 

shouldn't speak for the -- so I think there is a the lot of 

impediments for a white knight coming in and taking down a 

pump and dump in a thinly capitalized stock. 

MR. LAMONT: I'm not sure that could be the 

solution in most cases, because when you short a stock you 

usually have to give 100 percent or more collateral. So it's 

not that George wouldn't lend me the stock. It's just that 

there is not a system set up where I can go to George and 
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say, "Look, quote me a rate, and I'll short that stock." 

It just doesn't happen. This is not an issue with 

most -- dollar-wise this is not a big deal. This is not the 

problem with IBM. This is a problem for tiny little micro 

cap stocks. 

MR. SPATT: I'd like to ask a question trying to 

pull us back a little bit to the subject of short selling but 

not specifically on the point of the pricing restrictions but 

on some related issues. 

There, obviously, were a number of calls for 

greater transparency of lending markets. What are the 

thoughts of the panelists with respect to greater 

transparency of the short selling market itself? 

And here I think in particular of the current 

disclosure of short interest, which is on a monthly basis, do 

folks think that's the right frequency? 

Do you think the markets would benefit from some 

other frequency with respect to the disclosure of short 

interest? 

MR. KYLE: I think that currently the ticker system 

in principle collects data on which trades would have been 

short sales and which trades weren't, but for the purposes 

of, say, academic research, that information is stripped 

away. 

So academics can't look at all the ticks for a 
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particular company's stock in a given day and identify 

exactly which ones were short sales. Is that right? 

MR. SPATT: I was posing --

MR. LAMONT: You want to go to the model of 

Singapore or Australia where they publish it contemporaneous. 

MR. KYLE: Let me make my comment, and then you 

can --

MR. LAMONT: Okay. 

MR. KYLE: Because I was going somewhere else with 

it as well. I actually think that labeling trades as short 

sales and telling the whole world a particular sale is a 

short sale is probably somewhat burdensome and not that 

valuable for the value of the information that you're 

getting. 

Having a tick system for the borrowing and lending 

market that reports a kind of open interest concept on a 

daily basis and reports here are borrowing transactions that 

are made, here is the rate that the borrowing transaction is 

made, you can have, kind of, a ticker for -- if it was the 

stock borrowing and lending market that is similar to the 

ticker that you already have for the trades in the stocks 

themselves. 

And now I do mean CFTC. Analogous to commodity 

markets they will report not only trades for the futures 

contracts themselves, but they'll report trades for spreads 
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and give you the spread differences, which are useful pieces 

of information that people do indeed look at. 

So why not do the same thing for stocks to create a 

transparent market for borrowing and lending not only for 

overnight borrowing and lending, but, if people wanted to do 

term borrowing and lending, you could report the terms, 

meaning the maturities and the rates, for term borrowing and 

lending. Put it on a ticker. It would make it much -- I 

think a much more efficient and much more transparent market 

for borrowing and lending than we have now. 

MR. HARRIS: There are two disclosure issues that 

we need to think about as we talk about these issues. First 

is the marking of the orders themselves. Should the orders 

be marked? 

And then the second issue I think is the one you 

referred to is should the aggregate short positions be 

reported. 

On the marking of the orders, I don't believe that 

they should be marked. Presently, marking the orders gives 

those people with access to the information an advantage 

that's not available to everybody else. 

If we are to insist upon marking short sale orders, 

then those orders ought to be marked to a world as a whole, 

but then there's a question of who gets the information 

first, and so forth. 
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And then I still have the problem of saying, well, 

why would we mark short orders but not long orders? And 

there's so many ways that somebody can go short from a long 

position. 

So for instance, somebody holds a very large market 

portfolio, and they tell their sponsors, their investors 

that, "What I'll do is I'll give you a market rate of return, 

but I will augment it slightly through a certain amount of 

short selling," and so forth. 

That person will be selling from a long position 

but, effectively, short selling. How would you discriminate 

among that from a regular long seller? So it's impossible. 

If we were to say that we do want to discriminate 

between these two types of selling, then the next natural 

question is, well, shouldn't we be discriminating 

between -- identifying the long buyers who are cash buyers 

and the long buyers who are margin buyers, which, of course, 

is probably an absurdity. 

But an equal absurdity at least in the same order 

of magnitude is the marking of the short orders. So the 

marking of the short orders I don't think is a good thing. 

It's a tip-off to who is generally better informed, and it's 

a disadvantage to the well-informed traders who are making 

our markets more informationally efficient. 

On the other issue, the net short positions, I 
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think it's important information because, at a minimum, it 

helps the short sellers understand what kind of risk they 

face with respect to short squeezes. 

It also seems to me a fundamental piece of 

information. When there is a difference between the shares 

outstanding and the actual float, it strikes me that people 

ought to know that. 

Now, the question, though, is at what frequency 

should they know it? Is it sufficient to know it on a 

monthly basis, or would it be better to report it on a daily 

basis? 

If you report it on the daily basis, then you're 

giving away the net flows of the short sellers, which is, 

essentially, revealing a relatively well informed order flow, 

and I'm not comfortable with that. 

Monthly seems a little bit slow to me from the 

point of view of trying to keep people from getting into 

trouble with respect to short squeezes. 

So probably the right answer is somewhere in 

between, which would indicate maybe every week. 

MR. LAMONT: I think we do have experience with 

other countries in Asia that do publish daily. I think 

there's two issues here. 

The first is that because there are special 

problems with short squeezes and getting bought in that short 
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sellers are more likely to be the victim of manipulation than 

other normal people because somebody else can interrupt my 

trade and suddenly, by manipulating the securities lending 

market, potentially force me to terminate my trade at a bad 

time. So that's one issue that would make me cautious. 

What I'm worried about is, you know, you publish 

stock ABC. It has a lot of short interest, and the CEO of 

stock ABC, who is a evil pump and dump guy, sees that and 

uses that information to somehow manipulate the securities 

lending market. Probably not likely to be a common 

occurrence, but it is a special thing regard to short 

interest, short sales. 

The second thing I want to mention is -- and I'm 

sure this is not what you had in mind, Chester -- but several 

years ago a few companies came up with a proposal that 

individual short positions should be published. 

Bruce mentioned transparency is always a good idea. 

Well, it's not always a good idea, and that would be one 

thing that would not be a good idea. Basically, that's just 

a list which says sue me, please, because I'm shorting your 

company. We wouldn't want that. 

MR. SPATT: And as Owen indicated -- as Owen 

surmised, my question wasn't actually directed about that but 

about the broader issues that he addressed and the others 

addressed. 
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MR. LEHMANN: My clothes are still on, so it's 

clear I don't believe in transparency. I was thinking about 

transparency of the lending market, and even nothing more 

than last sale reporting, if there's a way to report what's 

going on in that market, as more shorts come around, they 

know that they're vulnerable to squeezes. 

They know who the other people playing in the same 

market are. That's what I meant. I think that has to be the 

idea. 

MR. COLBY: Could I go back and talk about ghosts 

that you may think you've exorcised already, and that's bear 

raids? I thought I heard this morning, I may have 

misunderstood it, that there was no evidence that there were 

bear raids being conducted, but I didn't hear it said that 

there was no evidence that they weren't or that they 

couldn't. 

Larry, I think I heard him say he's much more 

concerned about pump and dumps than he is about bear raids. 

Rich, I thought I heard him wonder whether there was such a 

beast any longer in this world. Could you all expand on the 

incidents, the likelihood of that phenomenon? 

MR. KYLE: When I was reading about the trial of 

Ken Lay, my understanding of Ken Lay's defense was that Enron 

was a victim of a bear raid. I didn't buy it. The jury 

didn't buy it. I don't know if anybody bought it. 
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But the bear raid is the story that a CEO tells 

when the market is voting against him. And people who like 

the CEO vote for him by buying the stock. People who don't 

like the CEO vote against him by selling the stock or even 

going further and shorting the stock. 

And the natural reaction of a CEO is I don't want 

people voting against me. I think it should be outlawed for 

people to vote against me. 

I think bear raids probably occur hardly ever, but 

there are some borderline cases that aren't exactly bear 

raids that would be like death spiral situations with 

convertible preferred stock where the company, essentially, 

sentences itself to death and asks the market to carry out 

the execution for it. 

That has the appearance of a bear raid, but it's 

something that the company itself, kind of, instigates, and, 

in some sense, the company itself bears responsibility for 

it. 

But outside of those peculiar cases who is going to 

complain about being able to buy depressed stocks at really 

cheap prices and earning a great return on that? Milton 

Friedman wrote a paper on the benefits of destabilizing 

speculation a long time ago that, kind of, had that point in 

it. 

If somebody wants to hammer a stock down to a 
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really low level, it's a great opportunity for other people 

to buy. They're going to earn a very high return. That 

would include the employees of the company that's being 

hammered down. 

If the company is a really sound company, it should 

benefit from that situation in the long run, if it has some 

people that do believe in the company. 

MR. LAMONT: There are -- short sellers an 

oppressed minority, and of every oppressed minority some of 

them are actually bad guys. So there have been documented 

cases of what you might call bear raids, which are illegal 

price manipulation involving short selling. 

So it is certainly something that takes place. As 

Larry mentioned, the number of cases involving that is 

dwarfed in terms of the number of cases by the number of pump 

and dump cases. It's also certainly dwarfed dollar-wise. 

I mean, Enron was a massive pump and dump, and that 

has harmed investor welfare way more than the entire history 

of short selling abuses in western civilization I speculate. 

An example of something, of a guy who was an 

illegal short seller, and I believe the courts have -- well, 

let me just say that there are examples in the past five 

years where the SEC has caught guys and prosecuted them and 

they've gone to jail for crimes involving short selling. 

So it's certainly something that our system is set 
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up to detect and is detecting. After September 11th there 

seems to be this idea that short sellers are evil, and if 

something bad happens it was probably done by a short seller. 

So after September 11th there was a massive manhunt 

for the alleged -- Osama bin Laden was allegedly short 

selling airline stocks on September 10th. So there was quite 

a search for nefarious short sellers after that, and they did 

actually catch a guy who didn't have anything to do with 

Osama bin Laden. So we certainly have the mechanisms in 

place to find them. 

MR. KYLE: The example of Osama bin Laden is 

insider trading, not a bear raid. Let's make sure we have 

the distinction right. A bear raid is I think a situation 

where you have a healthy company, and somebody decides I'm 

going to destroy this company by destroying its stock price. 

Despite the fact that the company is economically 

sound, I'm going to somehow do it by -- destroy it by making 

the stock price cheap. And that would be a form of 

manipulation. 

The other side of that coin and something that is 

quite the opposite is insider trading where you have some 

information, for example, that Enron has got some fraudulent 

accounting going on that you picked up which you could 

actually have done by reading Enron's 10-K. 

That's not even insider. That's what I'm saying. 
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It's just informed trading. If you got the information 

improperly, it would have been insider trading, if you were 

inside Enron, as opposed to manipulation. 

And the distinction is that whether you call it 

insider trading because it's information misappropriated, 

let's say, from the firm or whether you just call it smart 

short selling because you read the 10-K very carefully and 

extracted from that that there was some partnerships that 

didn't look very appropriate you're driving the price towards 

its fundamental value, which, in the case of Enron, I 

suppose, was zero. 

I wouldn't call that a bear raid. I would call 

that either insider trading, if you're privy to private 

information inside the firm that weren't supposed to be 

trading on, or I would call it just smart informed trading 

based on good research, if you had figured that out from 

reading the 10-Ks. 

MR. COLBY: If I broaden the definition of "bear 

raid" some, I wonder if it affects anyone's view. If it's 

not to destroy the company, but it's intended to start a 

visible progression downwards to try to make holders afraid 

of the direction of the stock and then induce them to sell 

with the hope of buying back at a very low price by driving 

the price down and bring everyone in in the same way, is it a 

different view, or is it only if you're trying to destroy a 
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company in the process that you think it's not occurring? 

MR. HARRIS: The classic bear raids that concerned 

people in the '20s and the '30s involved stocks where people 

had bought the stocks very heavily on margin where the margin 

requirements were much, much lower than they presently 

are. So people could acquire large positions on a 

shoestring, which allowed them to get into trouble in the 

price dropped. If the price dropped, they'd be in trouble 

with their broker, and then a forced sale was ensue, and that 

would cause the price to drop further, allowing the 

manipulator to buy at the bottom and profit. 

So to some extent, our concerns about bear raids 

are very closely related to the margin requirements that we 

have on stock. At 50 percent now those are not anywhere in 

the same order of magnitude as the requirements that we saw 

in the '20s. 

MR. COLBY: May I interject just to note that there 

are proposals to start the initial margin at 15 percent that 

are with the Commission, 15 and downwards depending on 

hedging. 

MR. HARRIS: Okay. Well, it's something to be 

concerned of along these arguments. Notwithstanding that 

it's worth reviewing why bear raids of the classic type that 

you've described are less common than pump and dumps. 

In a bear raid, the manipulator sells stock and 
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then hopes that the stock will drop so that he can buy it at 

a lower price. In order for that to happen, he has to have 

other people to sell the stock along the way, and typically 

those are long holders or possibly other short sellers, and 

then he'll buy at the bottom from those folks. 

The long holders are not great candidates for 

manipulating because they already bought a stock that they 

know a lot about the company, presumably. They liked the 

company when they bought it. 

Because they're well informed about the company 

they may buy more stock as the price drops, and it's hard to 

get people to short sell what they don't know, and, in 

general, most people don't short sell because they don't know 

much about it. 

To the extent that they know about it, they know 

that they're exposed to unlimited losses, so it's hard to get 

people, especially uninformed people, to become short 

sellers. 

In a bear raid, it's hard to get people to follow 

your selling. In a pump and dump, the object is to buy 

the -- the manipulator's object is to buy it and get people 

excited about the stock and then sell it to them as the price 

rises. 

Now you have a universe that's full of everybody 

who reads their e-mail who potentially could be buying the 
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stock, many of them uninformed, and because that universe is 

so much larger and full of so many other people who are 

uninformed it's much easier to fool them than it is to fool 

the long holders in a bear raid. 

So I think that probably explains the reason why 

the Commission sees so many -- which is generally aware that 

there's so many pump and dump problems relative to the bear 

raid problems, that and of course the difference in margin 

treatment that we see now. 

MR. LAMONT: If I could just add, Larry, there's 

some other problems there. Let's go back to the case of 

Enron. I mean, Enron had a lot of things on its side that 

the short sellers didn't have. 

Enron controlled the accounting information. Enron 

bullied the analysts. Enron had the underwriters. So the 

long frauds have way more tools at their disposal to 

perpetrate the frauds than the shorts do. 

So it seems like that's another reason why we're 

more likely to see fraud on the long side. It's just easier. 

Our system is set up such that the long people have more 

tools. 

MR. KYLE: The definition of a "bear raid" that you 

gave can take place over many different horizons. So at the 

shortest of short horizons, it's front running. You've got a 

customer that either has a stop loss order in the market or 
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is about to place a sell order, and you want to, kind of, 

trade ahead of that customer so you short the stock. 

And by shorting the stock, you drive it down and 

either trigger the customer's order, or you knew the 

customer's order was coming anyway, and you cover maybe by 

trading on the other side of your customer. That's front 

running. It's misbehavior with regard to your customers, and 

you could call that your little shortest of short horizon 

bear raids. 

The tick tests that we're talking about today may 

have a side effect of, kind of, making that a little bit more 

difficult but I think at an inconsequential level. As you 

get to longer horizons you have things like portfolio 

insurance. 

Portfolio insurance is a, kind of, preannounced 

strategy of I'm going to sell billions of dollars of stock if 

there's a substantial decline in the stock market. So the 

question arises would it be a legitimate strategy or 

desirable strategy for speculators in the market to sell 

first? 

That raises an interesting question, because if 

they sell first portfolio insurers are, presumably, going to 

do what they said and continue to sell, and the next thing 

you know you have, kind of, a downward spiral to the stock 

market. 
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And I've got to give the SEC credit on this. You 

did a multi-hundred page study of the stock market crash of 

1987 months before it actually occurred and had the scenario 

spell out perfectly and informed the market that you thought 

this was an issue. 

And presumably, the cure for that issue would have 

been for people to go on and sell earlier rather than later 

to get the market to a level that was an appropriate level. 

So if you don't allow people to take actions to, essentially, 

protect portfolio insurers from themselves you're likely to 

wind up with a very inefficient market and people getting 

hurt. 

MR. SOFIANOS: It seems to me we left aside a 

little bit of the empirical evidence presented this morning, 

because it seems to me that based on the empirical 

evidence -- I don't know how much of a problem bear raids are 

or not, but it doesn't seem that the tick test affects them 

one way or another. 

Perhaps we could -- and again I'm turning to the 

academic researchers in the audience who could refine the 

test more specifically for this particular kind of event. 

But I would have thought if it was an issue of tick test 

affected the possibility of a bear raid we would have seen 

something in the data that already has been analyzed. 

MR. COLBY: Could I take this to a different point 
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now? And that is that another thing we touched on and in 

particular Pete talked about is the effect of the tick test 

in extreme volatility conditions. 

I just wonder if we could hear of views of 

other -- Pete, again, if you'd like, another panelist on 

that, because these papers were done in a time of relatively 

low volatility. 

What do you think the impact of the tick test or 

lack of a tick test in an extreme upward or downward rise? 

We should focus on downward, because upward wouldn't be a 

valid for the tick test. 

Pete I know has talked about it being implicitly an 

unfair discriminatory form of a circuit breaker if I 

understood what you're saying. I wonder if other people 

would like to comment or you'd like to expand. 

MR. LINDSEY: Well, if I interpret Pete correctly, 

and I'm sure he can speak for himself, he, basically, said it 

was a bad form of circuit breaker, because, basically, you 

had an accumulation of short sell interests that wasn't being 

reflected in the market quickly enough. 

And you had, essentially, an overhang that at some 

point could, in theory, come off. Now, of course, if it's 

all downticks at any given point in time, you probably can't 

get that overhang to come off, because the shorts are not 

going to happen that way. 
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We can go into a very long debate about whether or 

not circuit breakers in any way, shape, way or form are good 

for financial markets. 

And the Commission has been through that a couple 

of times on the pros and cons and whether or not you should 

have individual circuit breakers on stocks or whether or not 

you should have circuit breakers on the markets at all or 

whether you should let the markets do whatever the markets 

do. 

I think that there's -- not to speak for everyone 

on the panel, but probably within the world of financial 

economists most people would kind of say let the markets 

behave as the markets are going to behavior. Don't put any 

artificial restrictions on them, and let them work. 

That may not be the appropriate policy decision. 

As was being pointed out somewhat humorously by Bruce about 

transparency, I think most financial economists would also 

say the more transparency the better. And particularly if 

you're an academic, the more data you can see the better. 

And that may not be the right public policy 

decision. Maybe we should have transparency where 

everybody's Social Security number is posted on the internet. 

That would be a form of transparency most of us probably 

wouldn't like. 

So it's really a matter of making that distinction 
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between what might be nice from an intellectual type of 

approach versus what's the appropriate thing for public 

policy. 

MR. SOFIANOS: I just wanted to reinforce what Rich 

said. To the extent that you do want to worry about unusual 

events and circuit breakers, I don't think the tick test is a 

way to go about dealing with events like that. 

MR. LEHMANN: In the traditional of echoing that 

happens to be going on, I'll echo that and just say it still 

really isn't clear to me precisely what the tick test is a 

remedy for. 

It's not a remedy for the bear raid. That just is 

not the right thing. It's not the remedy for limit orders 

being deep on one side of the book and shallow on the other. 

If you don't see that, you can't notice it. 

But if you see tons of sell limit orders hanging 

out there way up and people just going down and down and 

down, that's the information you need transparency of the 

book. 

It seems like the tick -- it can't be for pump and 

dump guys. All you've got to do is do a pump that's 2 bucks 

a share and just spread your trades outgoing up, and when it 

stops going up you close out the ones at the end, and you 

lose on a few of them. Pump and dump has nothing to do with 

a tick test. 
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A tick test has to do with solving a problem that's 

very, very temporally specific which at this particular 

moment in this particular configuration of recent price 

movements we're going to stop a person from selling something 

they don't own, and that's not a good circuit breaker. 

A circuit breaker should be designed for the 

circuit it's supposed to be breaking. I'm really not sure 

what thing is trying to be broken here. 

MR. KYLE: I was simply -- when referring to this 

as circuit breakers, the tick test creates this queue of 

orders that in normal time shows up as a large supply of asks 

relative to other stocks. 

In abnormal times, it shows up differently in 

different countries depending on how their circuit breakers 

work. To take an example of, like, Japan where they -- I'm 

not sure how they do it right now, but they used to have it 

where after the stock traded down several cents or several 

notches you'd take, like, a one-minute or five-minute break 

because you weren't allowed to place offers at lower prices. 

So you would see this big overhang of orders, but 

you didn't know how much further down it would need to go to 

clear out that overhang. That's a circuit breaker is looking 

at a big overhang of orders and not knowing how much further 

down it's going to go because trading has been stopped 

because the circuits have been turned on. 
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MR. LEHMANN: Actually, Japan -- just for the sake 

of information, Japan, if you're going down two ticks in a 10 

yen, the stock is stopped there. The screen flashes 

advertising immediacy, and it usually hits within a few 

seconds. But the thing that goes for a long time doesn't 

happen hardly at all. 

MR. KYLE: In a crash scenario in Japan, everything 

is flashing, and there are just big overhangs of orders, and 

that's your circuit breakers at work in a crash scenario. 

MR. HARRIS: I think it's useful not to lose 

perspective on the fact that there are so many different ways 

to get around the tick test. We're arguing about its 

potential benefit without recognizing that even if you 

thought it had a benefit -- we don't think it does -- there 

are so many ways around it it's, essentially, an 

unenforceable piece of regulation. 

So what's presented in front of us is potentially 

an opportunity to get around an ineffective regulation that 

has no real value associated with it. You, sort of, wonder 

if the Commission can't get rid of this type of regulation it 

will never be able to get rid of any unnecessary regulation. 

MR. COLBY: I once got rid of a regulation that as 

far as I could tell had not been used in maybe decades, and 

the information was sitting behind a secretary's desk. And I 

was subsequently -- not personally, but the elimination of 
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that rule was fingered as a factor in the 1987 crash. So 

there are negatives to getting rid of regulations. 

MR. HARRIS: Make no mistake that there are 

constituencies that care very much for this rule besides just 

the corporate managers, and so forth. In particular, anybody 

who sees the order flow that's marked has an advantage, 

because it's well known that the short sellers tend to be 

better informed than other sellers. 

So anybody who sees a marked order flow has a 

strong interest in maintaining this rule as long as it's not 

too binding on their own trading. 

MR. COLBY: One small follow-up. As I listened to 

the studies this morning it seems that there was an 

impediment to trading into shorting from the short sale rule. 

So what would you attribute the fact that short 

sales are still being done in the equity markets, as opposed 

to these other possible ways to take a short position? Is it 

an efficiency matter? 

MR. HARRIS: You've seen evidence that the rule has 

effect, because we see that there is some statistically 

significant but not economically significant difference 

between two samples where there are good controls on the 

composition of the samples, and so forth. 

But it's not really economically different. I 

mean, the differences aren't economically significant in any 
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means. The rules exist. People are abiding by the rules. 

They're adjusting their trading strategies in reflection of 

those rules, but by and large they're able to get their 

trades done in certainly the more actively traded stock 

because there are so many ticks available. 

They're getting them done in the Nasdaq stocks 

because you had a couple major venues where the bid tick test 

isn't being enforced because they weren't required to, and so 

everybody short selling is going to send to those venues. 

I mean, it's no surprise at all you got no effect 

in that market. The world seems to be continuing along just 

fine. It keeps compliance attorneys in work. 

MR. SPATT: I'd like to ask a couple of maybe 

broader questions as we start to wind down. We've focused to 

some degree in the panel on the tick test, not completely. 

And we've also talked a bit about other markets, including 

the lending market, and we had some interesting discussion 

about the lending market. 

So in general do you feel that markets treat short 

sellers appropriately, or is it environment too harsh or too 

lenient for short sales? Certainly, my take-away from a lot 

of the discussion today is that the tick test is simply sort 

of a minor -- it's a cost on short selling, but it's a pretty 

minor one. 

Are there other broader impediment -- particularly, 
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if there are broader impediments, are they regulatory in 

character, or is it just, sort of, fundamental about the 

nature of what short selling is about? 

MR. LINDSEY: The tick test may be a minor thing, a 

minor impediment, but it's a little bit akin to if every time 

you get in your car --

MR. SPATT: I wasn't defending --

MR. LINDSEY: No. Let me finish. If every time 

you get in your car you have to, kind of, rock the steering 

wheel back and forth before you can get your car started, you 

know, it's just an impediment. 

You can always get your car started, and you can 

always get to work, but it doesn't mean that you like it, and 

it doesn't mean that it makes your life particularly easy. 

So it's a little bit -- I think Owen has used the 

phrase that, you know, short sellers are an oppressed 

minority a couple of times, but it's a hassle in terms of 

their activity in the market. When you really want to do it 

as professionals, it can get done, but you have to jump 

through a hoop that, kind of, makes no sense in terms of its 

normal application. 

So from that standpoint, you know, I don't want to 

downplay the fact that, gee, since it's only a minor 

inconvenience therefore there's nothing we should do about 

it, I would still argue that there should be something done 
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about it. 

MR. SPATT: Let me also sort of say in my question 

I wanted to really emphasize whether there were other aspects 

of the way implicitly or explicitly short sales are regulated 

that impose -- either do impose other burdens relative to 

long transactions or perhaps don't. 

MR. KYLE: I think I said this earlier, but I'll 

repeat it. If you're an unsophisticated trader and you want 

to go short, my understanding -- I've never done that before, 

and maybe I am not as sophisticated, but my understanding is 

you wouldn't get the rebate that the market would probably 

give you if you were more sophisticated and knew how to ask 

for it. 

So in that sense, retail investors are probably 

well-advised not to engage in a lot of short sales because 

they are, essentially, discouraged by lack of transparency 

and lack of getting the benefits of the rental rates for 

securities. I said it wrong. If a retail investor sells 

short, he may not benefit as much from the low borrowing cost 

as he should. So that's an issue but not a big one. 

MR. HARRIS: I was going to make the same point. 

Let me add to it. I have a fair amount of experience short 

selling as a retail investor. 

To my experience for my size account there 

has -- there's only one broker out there that is offering 
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short interest rebate, and I've called up a lot of brokers, 

full-service brokers, discount brokers, and the like, and 

dangled in front of them million dollar accounts with million 

dollar short positions, not that I had that but that I was 

trying to see where the line was where they'd actually say, 

"Okay. Well, I'll take it." 

These are extraordinarily lucrative accounts for 

the dealers -- for the brokers, because the brokers take the 

short interest proceeds, and then invest them. 

So for example, if somebody is holding a million 

dollars in short positions, that represents $50,000 a year in 

interest income that potentially could be rebated back. 

Now, there's one retail broker now who will provide 

it, and that's a very sophisticated broker, but otherwise 

they wouldn't do it. And I pressed everyone. I come back 

with the overwhelming notion that I can't substantiate as an 

economist and certainly not as an attorney that there's a 

tacit collusion that nobody wants to break. 

Now, I understand that dealing with short sellers 

is more expensive for the broker. They expose the broker to 

various problems, including unlimited liability, but those 

brokers are already exposed to those types of problems with 

people who take short positions in options, and they're 

certainly willing to offer those to their retail customers. 

So my only conclusion is that there probably is a 
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tacit conclusion here. That's not necessarily a regulatory 

problem. It would be a failure of somewhere else. But I've 

always been very surprised that there's so much money in that 

business that doesn't go back to the retail client. 

That's one answer to your question. The other 

answer is that -- we were talking before there's still a big 

problem with settlement failures, so we've argued for the 

benefit of allowing people to be naked against pump and dump 

situations. 

A trade that is arranged between two parties for a 

three-day settlement that gets converted into a indefinite 

settlement really represents a renegotiation of the trade on 

a bilateral basis from a cash settled security contract to a 

open-ended futures contract. 

And that's a very significant problem, and the 

problems associated with it are twofold. First of all, the 

buyer doesn't get the security and therefore can't loan it, 

and these securities are securities that are on special so 

that the loan fees would be significant. 

Buyers typically don't know about it. Certainly, 

you'd think the brokers would care about this, but because 

they're on both sides of it I don't think they're too 

responsive. 

The other problem is a problem having to do with 

corporate governance and the question of how many people out 
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there think that they own the stock and are able to exercise 

their votes. 

If somebody buys a stock and think that they're 

actually buying the stock and then can't vote it, that's a 

significant problem. 

The solution to the problem, Pete suggested one 

that I've always been partial to, which is an escalating 

schedule of penalties, but the problem with that also is it 

still exposes -- it's sort of a compromise position. 

It exposes people to the possibility of getting 

caught in a squeeze anyway. Now the squeeze is going to be a 

financial squeeze that's enforced by whatever entity is 

collecting those fees. 

Probably what's needed is a mechanism where it's 

easier to open up the futures contract that I just described. 

The individual security futures contracts have been difficult 

for a variety of reasons, but here's a particular 

circumstance where you'd think that they would work very well 

but where you would never authorize them apriori or wouldn't 

be thinking of doing it. 

So a futures contract on a pink sheet stock is just 

not sort of a normal thing, but these are the ones that are 

getting manipulated. 

So if necessary, perhaps you could somehow let that 

market get created so that people actually knew what they 
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were trading, that they were going to buy something but that 

they really weren't going to get settlement and then somehow 

impose a requirement on the brokers representing the buyers 

that the buyers need to be advised that there's a market out 

there where you could buy this thing a lot cheaper than you 

otherwise could. And are you really thinking you want to buy 

it for cash settlement, or do you want to buy it for future 

settlement? 

That by itself opens up a huge bunch of problems, 

but these are the types of issues that will have to be 

engaged to ultimately solve this issue. 

MR. SPATT: And I have one final question, again a 

broader kind of question and actually one not directed even 

at short selling specifically. 

I noticed in the panel this afternoon and indeed 

among many of the panelists this morning praise for the 

Commission and staff for the design of the pilot and in 

particular for, basically, structuring a natural experiment 

to create evidence that would inform this rule-making. 

Are there broader lessons from this, do you think, 

about the types of situations in which such an appropriate 

might be used to inform rule-making in other contexts? 

Clearly, in many contexts this type of approach wouldn't 

work. Do you have perspectives with contexts where this 

natural experiment approach might be beneficial in the 
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context of rule-making? 

MR. LINDSEY: Well, I think one of the places or 

one of the things that's important in terms of doing 

it -- and I agree. I think this is a great experiment, and I 

think there was some great papers this morning that I thought 

were terrific in terms of the work. 

And I think the Commission should be praised both 

for what they did in terms of the pilot program but also in 

terms of this type, and I meant to, kind of, mention it 

earlier. It's the first time in my memory, I think, that the 

Office of Economic Analysis has had a session like this to 

discuss on a broader sense some type of let's call it market 

experiment. 

So I think that's a very good venue and something 

that should be pursued. What was a little unique in the Reg 

SHO pilot was the fact that you have everything going through 

a few marketplaces, and markets could, essentially, 

centralize the activity associated with the modification of 

the systems so the experiment could be conducted. 

If, on the other hand, the experiment needed to be 

conducted so that, you know, 8,000 market participants -- to 

just choose, like, broker dealers, or whatever -- but if 

8,000 market participants each had to modify their systems to 

conduct the experiment, I think that would be a terrible 

waste and a great inefficiency. 
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So it really -- while I think the experimentation 

is very good, it is best if it's, kind of, focused in an area 

where it's not going to be prohibitively expensive to conduct 

that experiment. 

MR. HARRIS: The bread and butter of the Commission 

is disclosure, yet the Commission knows very little about 

what makes for effective disclosure. 

We know from disclosed data and, if it's possible 

for people to actually read the data -- of course the 

Chairman is very interested in this issue right now -- then 

people will be able to process it. 

But there are places where people have to process 

the data themselves as individuals; for instance, with 

prospectuses, and so forth, where issues about labeling, how 

things are presented, become very, very important. 

The Food and Drug Administration spent a 

considerable effort in figuring out how to produce labels on 

our food packages that I find to be extraordinary useful. 

That was the result of scientific studies that experimented 

with alternatives not necessarily in the type of experiments 

that we have here with Reg SHO but involve scientific 

experiments to determine what was effective. 

We have the same disclosure issue with respect to 

mutual funds, and so forth. It would be interesting and 

important to figure out what really needs to be disclosed and 
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how it should best be formatted so that people can obtain the 

greatest value from it. 

That's not to minimize the importance of all the 

other disclosure that goes on in the form of the NSARs in the 

backs of the prospectuses, but what appears on the front 

should be designed for maximal effectiveness. It would be a 

small use of money compared to its value. 

MR. LEHMANN: I would add not anything about 

specific things that should be done but about experiments. 

You really can't hope to learn about things that will have 

permanent impacts from an experiment. 

To give an example that I hate, you can learn about 

the effect of a temporary transactions tax, but you can't 

learn diddly about a permanent transactions tax. And 

disclosure is like that. 

You can learn something about more timely or 

differently timed disclosures, but you can't really learn 

about disclosure. You've got to be doing something that is a 

temporary remedy for some temporary problem. 

I just don't think you can experiment with making a 

better prospectus, although believe me I think a lot of 

improvements could be done in that domain. 

MR. KYLE: I think there are potential experiments 

that could be conducted in the disclosure area, especially on 

accounting issues, because, as Larry suggested, there are 
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areas where information is disclosed such as, say, stock 

option expensing or other fair value accounting type issues 

where the information is going to be disclosed somewhere. 

But many people think that the way in which it's 

disclosed actually has an effect on the way in which 

securities are valued in the marketplace. So I think that 

there would be potential benefits when different accounting 

issues come up to maybe applying them to a randomly selected 

group of stocks. 

And then I can guarantee you the accounting 

professors around the United States would study that very 

thoroughly, and you'd learn something. 

MR. SOFIANOS: I think the question should always 

be asked when contemplating a rule change or a new rule is 

this rule change or new rule something we could do a study, 

do an experiment beforehand. And if the answer is yes, then 

it should always be done. It should be part of the process. 

But clearly there's a large number of cases where it's not 

possible to design an experiment. 

MR. HARRIS: I would note for completeness that 

there are some political aspects of experimentation that 

ought to be mentioned. 

Who gets included in the experiment will be very 

important to some people, especially if the issue is very 

important. We were able to do this SHO experiment because, 
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frankly, most people it wasn't going to make a big difference 

and be able to include a third of all stocks or a third of 

all the big stocks. And so whether you were in or not it 

wasn't like you were being singled out in any special way. 

But if you start touching something that's really 

important, you're not going to be able to do it with a third 

of all stocks. You're going to have to do it with, say, 50 

of 5,000 stocks, at which point the 50 who are involved in 

one way or another are going to be very concerned about that. 

And that's makes it very difficult. 

I think it's very important that we do this type of 

stuff, but there are some political difficulties that we 

should be aware of as we discuss the issue. 

MR. COLBY: I should just add that those of you who 

worked on it know that it was not at all clear that wasn't 

going to be very politically controversial at the time also. 

MR. SPATT: I remember. I happened, as a member of 

the public, to be at the open commission meeting when this 

was discussed, and there certainly was concern reflected at 

the time that some issuers -- there was concern that some 

issuers might potentially be very concerned if they were 

going to be in the pilot as compared to the control sample, 

although, you know, I think, obviously, that has not been a 

huge issue. 

Well, I think at this point -- it's about 3 
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o'clock, and I think Bob and I have just about exhausted our 

questions. I wanted to again thank the panelists for coming 

here today and for sharing with us their wisdom about the 

pricing restrictions, about short sales, about lending 

markets and a host of other issues. 

We appreciate very much your taking the time to 

share your thoughts with us. 

(Whereupon, at 2:59 p.m., the roundtable was 

concluded.) 

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