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SEC's Short-Sale Guidance May Call for IT Adjustments
July 10, 2006
The Securities and Exchange Commission is close to amending its rules governing short selling, and industry participants expect the changes to burden brokers with increased and more specific reporting requirements. One concern is that the changes will force significant upgrades in the trading, settlement, order entry and audit systems of the prime and executing brokerages that serve hedge funds.
In the works for more than a year, the changes will come this summer via a revision to a 1994 no-action letter, also referred to as the "prime broker letter," that addresses the practice of naked short-selling. The amended letter is intended to strengthen the SEC's oversight of short sales under Regulation SHO, which took effect in January 2005.
Brokers have spent the past several months testing some system modifications to accommodate the changes. But with the details still unavailable, many brokers and buy-side firms fear they may be forced into making additional investments in their platforms. What's more, some believe the effort will yield little practical benefit to regulators, who have waged a long campaign to clamp down on naked shorting.
These concerns, particularly those about technology costs, came up in June during a panel discussion on prime brokerage at the Securities Industry Association's Hedge Funds and Alternative Investments Conference.
"To the extent that there are systems changes or other significant business changes to be made, we appreciate that there needs to be some time to do that," said James Brigagliano, the SEC's acting associate director in the division of market regulation. He added that the effective date on the new guidance may be delayed to give market participants time to modify their systems.
Other panelists expressed concern about the impact. "I think the view of the industry is that to get into a more detailed referencing probably doesn't add a lot of value, [but] does add a lot of technological cost," said Michael Rogers, associate general counsel at Banc of America Securities.
The SEC is discussing with the securities industry whether dealers should include the specific amounts of a customer's borrowed shares, as well as the exact time of day that prime brokers determine a reliable source, or lender, of the shares to be borrowed, also known as a "locate," for customers engaging in equity short sales. Since it went into effect, Reg SHO has had only limited success in reducing fails; one of the SEC's objectives is to improve the audit trails for locates.
Michael C. Neus, general counsel at New York-based hedge fund Perry Capital, said: "I think it's going to have a highly disproportionate effect on some [funds] as opposed to others. It depends on what level of detail is required. But I'm not sure the electronic order-entry systems can do what's proposed now without a great deal of modification. That's not to say it couldn't be done, but it depends on what's actually required." Although some order management systems include tracking and time-stamping features for locates, funds tend to provide this information to their brokers by phone or e-mail.
A November release of Omgeo's TradeSuite post-trade confirmation system added features designed to help brokers comply with the new mandates. Version 6.0 includes a field that lets brokers indicate whether the customer is long or short on a deal, so brokers can match on that aspect of trading. If the indications diverge, the prime broker can notify the executing broker of the problem via what's called an "advice of cancel/correct" message, to amend the trade.
