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Regulation SHO – Bona Fide Market Making Exemptions and Reuse of Locates for Intraday Buy-to-Cover Trades

NEW FOR 2023

Regulatory Obligations and Related Considerations

Regulatory Obligations

Rules 203(b) (Short sales) and 204 (Close-out requirement) of Regulation SHO provide exceptions for bona fide market making activity. The SEC has provided guidance on what constitutes “bona fide market making activities” as well as examples of what does not; member firms must also confirm and be able to demonstrate that any transaction for which they rely on a Regulation SHO bona fide market making exception qualifies for the exception, consistent with Regulation SHO and guidance.1 For example, reliance on and compliance with an exchange’s market making designation and quoting requirements does not per se qualify a market maker for the bona fide market maker exception. Only market makers engaged in bona-fide market making in the security at the time they effect the short sale may rely on the exception.2

Rule 203(b)(1) of Regulation SHO requires that, prior to accepting a short sale order or effecting a short sale order in an equity security for the broker-dealer’s own account, a broker or dealer must borrow the security, enter into a bona fide arrangement to borrow the security or have reasonable grounds to believe that the security can be borrowed so that it can be delivered on settlement date (i.e., receives a “locate”). Pursuant to SEC guidance, if a broker-dealer receives a locate for a short sale order that is executed and subsequently covered on the same day, the broker-dealer may reuse that locate for a subsequent short sale order, provided that the subsequent short sale order is for a quantity no greater than the quantity of the original locate, and the original locate was deemed by its source to be good for the entire trading day.3 For a "hard to borrow" security or a threshold security, however, a broker-dealer may not re-apply a locate for intraday buy to cover trades.4 SEC guidance has explained that, without obtaining locates prior to each short sale in hard to borrow or threshold securities, it is unlikely that a broker-dealer executing short sales in such securities would have reasonable grounds to believe that the securities can be borrowed so that they can be delivered on the date that delivery is due on each trade.5

Related Considerations

  • How do your firm's supervisory systems ensure that short sales your firm executes in reliance on a Regulation SHO bona fide market making exception qualify for that exception?
  • What is your firm's process for determining if it can reasonably satisfy Reg SHO's locate requirement prior to executing short sale transactions?
  • If applicable, when your firm reapplies a locate for short sales executed after intraday buy-to-cover trades in reliance on Question 4.4 in the SEC Reg SHO FAQs, does it take steps to ensure that it doesn’t execute short sales of threshold or hard-to-borrow securities?

Findings and Effective Practices


  • Non-Bona Fide Market Making: Failing to distinguish bona fide market making from other proprietary trading activity that is not eligible to rely on Regulation SHO’s bona fide market making exceptions, which includes:
    • quoting only at maximum allowable distances from the inside bid/offer (e.g., using peg orders);
    • posting quotes at or near the inside ask but not at or near the inside bid;
    • only posting bid and offer quotes near the inside market when in possession of an order; and
    • displaying quotations that are not firm and are only accessible to a small set of subscribers to a firm’s trading platform.
  • Impermissible Reuse of Locates: Relying on the guidance under Question 4.4 of the SEC’s Reg SHO FAQ but not taking steps to confirm that locates are not reapplied to short sales of threshold or hard to borrow securities, or not having a process in place to prevent the execution of any short sale orders in threshold or hard to borrow securities that involve the application of locates.

Effective Practices

  • Supervision of Bona Fide Market Making: Developing supervisory systems for, and conducting supervisory reviews of, market making activity to ensure that any reliance on Regulation SHO bona fide market making exceptions is appropriate by considering, for example:
    • where the firm’s quotes are placed, and how (e.g., market participants vs. ATS visible or non-visible orders);
    • the frequency or timing of the firm’s quoting activity (e.g., morning or evening vs. throughout the trading day); and
    • the level of the firm’s proprietary trades compared to customer transactions filled.
  • Supervision of Reuse of Locates: Developing appropriate policies and procedures to adhere to the guidance provided in Question 4.4 of the SEC’s Regulation SHO FAQ, as applicable, such as:
    • using hard blocks on threshold securities, or easy to borrow lists, as limits on reuse (e.g., setting systems to check and allow reuse only in securities deemed easy to borrow, rejecting short sales in securities not deemed easy to borrow without the locate); and
    • confirming that agreements with locate providers specify for how long the locates are valid (e.g., only the day issued). 

Additional Resources

1 See e.g., 69 FR 48008 at 48015; and Question 4.7 and 4.8 of the U.S. Securities and Exchange Commission, Responses to Frequently Asked Questions Concerning Regulation SHO (Oct. 15, 2015) (SEC’s Reg SHO FAQs).

2 See Question 4.4 of the SEC Reg SHO FAQs.

3 See Question 4.4 of the SEC Reg SHO FAQs.

4 Id.

5 Id.