By Nina Mehta - Sep 27, 2010

Regulators should consider giving market makers more latitude to sell stock short to ease the burden of increased obligations that may be imposed on those firms, according to an executive at Knight Capital Group Inc.

Market makers sometimes can’t sell stock in response to demand because some securities that aren’t actively traded are hard to borrow, Jamil Nazarali, global head of the electronic trading group at Knight Capital Group Inc., said at a Security Traders Association conference in Washington on Sept. 24.

“More latitude around being able to short stock” would offer market makers relief, Nazarali said. Brokers that make markets by providing bids and offers for investors to trade with should be allowed to maintain short sales for longer than the current period, he said. In a short sale, borrowed shares are sold with the aim of profiting by later buying back the stock at a lower price.

The U.S. Securities and Exchange Commission is considering new obligations and benefits for market makers to ensure that sufficient liquidity is available in times of volatility. SEC Chairman Mary Schapiro has said the agency may give market makers new benefits that will entice them to accept heftier commitments following the May 6 plunge that briefly erased $862 billion in U.S. equity value in less than 20 minutes.

“When an investor wants to buy certain stocks, market makers can’t always sell them short” to meet that need because they must provide the borrowed shares even in less actively traded stocks, Nazarali said. “In these thin names, that’s when you need a market maker the most.”

Motors Liquidation

For instance, last year Knight wanted to sell short Motors Liquidation Co ., the firm formed to liquidate the assets of automaker General Motors Corp., which filed for bankruptcy protection in 2009. Knight couldn’t because that would have required closing out the positions by delivering shares prior to the start of trading on the sixth day after the transaction, which it couldn’t do, Nazarali said.

Motors Liquidation traded at around $1 during the middle of last year even though the equity shareholders would eventually be wiped out, Nazarali said. Because Knight and other market makers couldn’t short the shares, they weren’t able to push the price lower. The shares trade for 35 cents now.

Knight, Getco LLC and Virtu Financial LLC in July urged the SEC to adopt stricter quoting requirements for market makers than currently exist on most exchanges. New obligations should require market makers to quote at the national best bid or offer, which represents the highest price at which investors can sell shares and the lowest at which they can buy, a certain portion of the day, Nazarali said. The three firms also said market makers should submit orders at several price levels.

Investor Costs

High-frequency trading firms RGM Advisors LLC, Allston Trading LLC, Hudson River Trading LLC and Quantlab Financial LLC countered on Sept. 14 that these requirements would raise costs for investors such as mutual funds without preventing market plunges.

Market makers who meet certain quoting requirements now receive an exemption from the obligation to locate shares for stocks they want to sell short and more-lenient terms than other investors for when they must deliver shares for bearish trades.

William Neuberger, global co-head of electronic trading at Morgan Stanley in New York, said at the conference that altering the obligations and benefits for market makers won’t ensure that they stick around in difficult times to buy when investors flood them with sell orders.

“If something’s happening in the world, why should they buy stock at the wrong price when things are coming down, down, down?” he said. “Even doing that doesn’t mean there won’t be another crash. It’ll just be a slower crash. They’re going to take the fine, basically, and live.”

source Bloomberg News 2010