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Regulation SHO – Bona Fide Market Making Exemptions

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. Additionally, a bona fide market maker must regularly and continuously place quotations in a quotation medium on both the bid and ask side of the market. 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 204 of Regulation SHO requires that member firms close out fails-to-deliver within established timeframes by purchasing or borrowing the relevant security by market open on the relevant close out date. Pursuant to SEC guidance, a member firm may use exchange-traded funds (ETF) conversion activity to meet the purchase requirement of the rule under certain circumstances as detailed in a 2017 SEC No-Action Letter. This position is limited to ETF conversion activity and does not extend to using American Depositary Receipts (ADR) conversion activity to comply with the purchase requirements of Rule 204.

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 that it is reasonably closing out fails-to-deliver in compliance with the purchase or borrow requirements of Rule 204?

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.
  • Use of ADR Conversions for Close Out of Fails: Impermissibly extending the SEC guidance regarding Rule 204 and closing out fails using ETF conversions to ADR conversions.

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 Rule 204 Close Out Activity: Developing appropriate policies and procedures to ensure that the firm’s close out actions consistently adhere to the purchase or borrowing requirements of Rule 204. 

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 (October 15, 2015) (SEC’s Reg SHO FAQs).

2 See Question 4.4 of the SEC Reg SHO FAQs.