Thursday, March 3, 2022

Disclosure and Beyond: Restructuring the U.S. Equity Markets

BRIEFING GUIDE to the SEC's Aggressive Agenda to Head off the Next "Big Squeeze"

Author: David Schwartz J.D. CPA

On Friday, February 25, 2022, the Securities and Exchange Commission (SEC) proposed its latest round of GameStop rule proposals. In addition to enhanced public disclosures of short sales by institutional investors, the Commission announced a 30-day extension of the comment period on its sweeping securities lending disclosure proposal, Rule 10c-1, and technical amendments to the "consolidated audit tape" regulations. The comment period for the short-selling disclosure proposals will be either 60 days following publication of the proposing news release on the SEC's website or 30 days following publication of the release in the Federal Register, whichever ends later. The Rule 10c-1 comment period is extended to April 1, 2022. These separate but related disclosure proposals may well be the start of a much broader and far-ranging regulatory response to the kind of market disruptions epitomized by the Gamestop event.  




These new rules, if adopted, would increase the public availability of data on short sales. Proposed rule 13f-2 under the Exchange Act would require institutional investment managers to report on the proposed new Form SHO information on end-of-the-month short positions and certain daily activities affecting these positions. This rule targets short positions of at least $10 million or equal to 2.5% or more of the outstanding shares of an equity security, or short positions of at least $500,000 in an equity security of a non-reporting issuer.i  


The Commission would aggregate the submitted data by security and release the aggregates to the public while keeping the reporting managers' identities (including the managers' LEIs)ii confidential. This new data is intended to supplement the publicly available short sale data from the Financial Industry Regulatory Authority (FINRA) iii and the stock exchanges.iv 


Chairman Gary Gensler stated that these new short sale disclosures would benefit investors as well as regulators, particularly when faced with conditions like those in the GameStop squeeze. 


"This would provide the public and market participants with more visibility into the behavior of large short sellers. The raw data reported to the Commission on a new Form SHO would help us to better oversee the markets and understand the role short selling may play in market events. It's important for the public and the Commission to know more about this important market, especially in times of stress or volatility." 




Current Reg SHO requires broker-dealers to identify sale orders as either "long," "short," or "short exempt." v  Proposed Rule 205 would add a corresponding requirement for purchase orders, requiring broker-dealers to designate orders as "buy to cover" if a buyer has any short position in the same security when the purchase order is entered. The SEC says this change would be helpful in "reconstructing significant market events and identifying potentially abusive trading practices including short squeezes" like GameStop. 




In light of proposed Rule 205, the Commission also proposes amendments to the national market system plan governing the consolidated audit trail (CAT). The amendments would require CAT reporting firms to report "buy to cover" information to CAT and includes a provision that would require each CAT reporting firm to indicate when it is claiming the "bona fide market making exception" under Regulation SHO




The Commission voted to reopen the comment period for proposed Exchange Act Rule 10c-1. In particular, the Commission is soliciting comments on any potential effects of the proposed short sale disclosures under 13f-2 that the Commission should consider in determining whether to adopt the proposed securities lending disclosure rules under Rule 10c-1 was proposed by the Commission on November 18, 2021, to increase the transparency and efficiency of the securities lending market. It would require any person that loans a security on behalf of itself or another person to report the material terms of those securities lending transactions and related information to a registered national securities association within 15 minutes of closing. The initial 30-day comment period for proposed rule 10c-1 ended on January 7, 2022.  


As many commenters pointed out, a securities lending reporting regime as complex as the one contemplated under rule 10c-1 raises vital questions about its practical aspects, as well as who bears the start-up and ongoing cost burdens and who, if anyone, benefits besides the SECCommenters across the securities lending industry said the 30-day comment period was insufficient and requested additional time to perform studies, evaluate and estimate costs, and propose potentially more effective alternatives to the rule 10c-1 regime. While the Commission has heeded commenters' request for more time, it has only allowed another 30-day comment period following publication of the notice in the Federal Register, expiring April 1, 2022.  




The GameStop squeeze was a complicated event that involved, among other things, short selling, securities lending, and broker behavior. The SEC has, at least initially, chosen to address each of these areas from the perspective of disclosure. But the Commission is working on an ambitious agenda of regulation to head off the next short-selling squeeze.  


1. Gamification of tradingSEC Chairman Gary Gensler has been vocal about investor protection concerns surrounding electronic platforms that encourage trading, making them more "gamelike." As Gensler said in an August 27, 2021 interview


“While new technologies can bring us greater access and product choice, they also raise questions as to whether we as investors are appropriately protected when we trade and get financial advice. In many cases, these features may encourage investors to trade more often, invest in different products, or change their investment strategy.” 


The SEC's report on GameStop highlighted gamification of trading as an area the SEC should focus on for regulation. 

“A number of features, which broadly include behavioral prompts, differential marketing, game-like features, and other design elements or features, appear designed to engage individual investors. These features, which have the potential to leverage large amounts of user data, raise questions about their effect on investor behavior.” 


"Consideration should be given to whether game-like features and celebratory animations that are likely intended to create positive feedback from trading lead investors to trade more than they would otherwise. In addition, payment for order flow and the incentives it creates may cause broker-dealers to find novel ways to increase customer trading, including through the use of digital engagement practices." 



2. Payment for order flowPayment for order flow (PFOF) may present a conflict of interest for broker-dealers who owe a duty of best execution to their clients. The SEC sums up this potential tension between PFOF and best execution in their 2000 Special Study on PFOF:  

“[P]ayment for order flow and internalization create conflicts of interest for brokers because of the tension between the firms' interests in maximizing payment for order flow or trading profits generated from internalizing their customers' orders, and their fiduciary obligation to route their customers' orders to the best markets.” 


The SEC's report on GameStop also listed the potential conflicts the practice creates as something the regulators are looking into closely.  


"Off-exchange market makers typically offer payment to the retail broker-dealer for the right to trade with its customer order flow (i.e., payment for order flow). These payments can create a conflict of interest for the retail broker-dealer." 


According to its latest public agenda, the SEC is considering proposing changes "to modernize rules related to equity market structure such as those relating to order routing, conflicts of interest, best execution, market concentration, and the disclosure of best execution statistics." These appear to be intended to address best execution issues raised by PFOF.  


3. Settlement CycleOn February 9, 2022, the SEC proposed rules to shorten the standard settlement cycle for most broker-dealer transactions from two business days after the trade date (T+2) to one business day after the trade date (T+1). Theoretically, shortening settlement times would wring some of the risk and leverage out of the market as retail brokerages would no longer be required to pay billions of dollars in extra collateral to guarantee trades if either party defaults. The Commission believes the move to T+1 will protect investors, reduce risk, and increase operational efficiency, and has proposed an aggressive effective date of March 31, 2024.   


In this context, a "non-reporting issuer" is one who is not registered pursuant to Section 12 of the Exchange Act or not required to file reports to the SEC pursuant to section 15(d) of the Exchange Act.  


ii Proposed Form SHO would require the disclosure of, inter alia, "the Name and active Legal Entity Identifier ("LEI") (if available) of each of the Other Managers Reporting for this Manager." See Rule 13f-2 Proposing Release at p. 212.  


iii FINRA makes two types of files available: (1) Daily Short Sale Volume Files; and (2) Monthly Short Sale Transaction Files (collectively, the Short Sale Files). The Daily Short Sale Volume Files provide aggregated volume by security for all short sale trades executed and reported to the ADF during normal market hours. See,,ADF%20during%20normal%20market%20hours 


iv The TAQ Group makes available for sale a summary of short sale volume for securities on NYSE, NYSE American, NYSE Arca, NYSE National, and NYSE Chicago (starting late 2019) throughout the trading day. See 


v "Short exempt" refers to a short sale order that is exempt from the price test of the Securities and Exchange Commission's (SEC) Regulation SHO. The current regulation allows for a limited number of situations where "short exempt" is appropriate.,order%20to%20a%20trading%20center. 


vi See at page 1. "The Commission is reopening the comment period for the proposed rule in light of the proposed Exchange Act rule regarding short sale disclosure. In particular, the Commission is soliciting comment on any potential effects of the proposed Exchange Act rule regarding short sale disclosure that the Commission should consider in determining whether to adopt the proposed Exchange Act rule regarding the reporting of securities loans."