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