Threshold securities

Threshold securities are a specific category of equity securities that have experienced persistent failures to deliver at a registered clearing agency. This designation falls under the broader umbrella of Market Regulation, specifically as defined by the U.S. Securities and Exchange Commission (SEC) in its Regulation SHO. The concept of threshold securities is critical to understanding regulatory efforts aimed at curbing abusive short selling practices, particularly naked short selling, which can lead to prolonged failures to deliver. When a security is designated as a threshold security, it triggers enhanced close-out requirements for broker-dealers, aimed at ensuring timely delivery of shares and maintaining orderly markets.

History and Origin

The regulatory framework for threshold securities emerged primarily with the adoption of Regulation SHO by the SEC in 2004, which became effective on January 3, 2005. This was the first significant update to short selling rules since their initial adoption in 1938. The SEC introduced Regulation SHO to address concerns about potentially manipulative short selling practices and a rise in persistent failures to deliver securities. Regulation SHO established "locate" and "close-out" requirements designed to prevent scenarios where shares were sold short without being borrowed or delivered in time for settlement.

Before Regulation SHO, some broker-dealers could engage in naked short selling, where they would sell shares they neither owned nor had arranged to borrow. This could lead to a significant increase in failures to deliver¹³. To combat this, Regulation SHO defined threshold securities and imposed stricter rules. The SEC also took more aggressive steps during periods of market stress, such as in 2008, when it issued emergency orders and adopted new rules to address abusive naked short selling, including eliminating certain exceptions for threshold securities¹². The New York Times reported on the SEC's actions in July 2008, highlighting concerns about such practices impacting market stability during that period¹¹.

Key Takeaways

Threshold securities are equity securities with a substantial and persistent number of failures to deliver at a clearing agency.
Their designation triggers specific close-out requirements under SEC's Regulation SHO.
The primary goal is to address prolonged fails to deliver, often associated with naked short selling, and promote market integrity.
When a security is on the threshold list, broker-dealers face stricter rules for borrowing shares before executing short sales.
These regulations aim to enhance investor protection and maintain market efficiency.

Formula and Calculation

A security is considered a threshold security if, for five consecutive settlement days:

The aggregate number of failures to deliver at a registered clearing agency is 10,000 shares or more.
The aggregate failures to deliver represent at least 0.5% (one-half of one percent) of the issue's total shares outstanding.
The security is included on a list published by a self-regulatory organization (SRO), such as NASDAQ or NYSE.

While there isn't a complex mathematical "formula" to calculate the threshold status itself, it relies on these three conditions being met concurrently over a specific period. The calculation involves monitoring daily fail-to-deliver data against the total shares outstanding.

To illustrate:

$\text{IsThresholdSecurity} = \begin{cases} \text{True} & \text{if } \left( \sum_{i=1}^{5} \text{FTD}_i \ge 10,000 \right) \land \left( \frac{\sum_{i=1}^{5} \text{FTD}_i}{5 \times \text{SharesOutstanding}} \ge 0.005 \right) \land \text{OnSROList} \\ \text{False} & \text{otherwise} \end{cases}$

Where:

(\text{FTD}_i) = Fails to deliver for a given settlement day (i)
(\text{SharesOutstanding}) = Total shares outstanding for the security
(\text{OnSROList}) = Boolean indicating if the security is on a self-regulatory organization's threshold list.

Interpreting the Threshold Securities List

When a security appears on the threshold list, it indicates a significant and persistent inability of market participants to deliver shares on time for trades that have occurred. This can be a red flag for potential issues such as abusive naked short selling or severe illiquidity in a security. The presence of a security on this list means that it is subject to the stringent close-out requirements of Regulation SHO, specifically Rule 203(b)(3)¹⁰.

For broker-dealers involved in transactions with threshold securities, this status means they are prohibited from effecting further short sales in that security without first borrowing, or entering into a bona fide arrangement to borrow, the shares, if they have an outstanding failure to deliver position in that security that has persisted for 13 consecutive settlement days⁹. This rule is designed to force the prompt resolution of outstanding failures to deliver and prevent further accumulation of undelivered shares. The SEC also provides public access to data related to fails-to-deliver, allowing some level of transparency into these market dynamics⁸.

Hypothetical Example

Imagine a small biotechnology company, "BioGen Innovate Inc." (BGI), with 50 million shares outstanding. For several weeks, there has been significant interest from short selling investors, betting on a decline in its stock price due to concerns about its drug trials.

For five consecutive settlement days, the aggregate failures to deliver for BGI shares at the National Securities Clearing Corporation (NSCC) are as follows:

Day 1: 15,000 shares
Day 2: 12,000 shares
Day 3: 18,000 shares
Day 4: 11,000 shares
Day 5: 14,000 shares

The average daily fails over these five days is (15,000 + 12,000 + 18,000 + 11,000 + 14,000) / 5 = 14,000 shares.
Since the aggregate fails are consistently above 10,000 shares.
Next, check the percentage of shares outstanding: 14,000 / 50,000,000 = 0.00028, or 0.028%.

In this hypothetical example, even though the aggregate fails exceed 10,000 shares, the percentage of shares outstanding (0.028%) is below the 0.5% threshold. Therefore, BioGen Innovate Inc. would not be designated a threshold security based on these figures alone. However, if the fails were, for instance, 250,000 shares per day, then the percentage (250,000 / 50,000,000 = 0.005 or 0.5%) would meet the second criterion, assuming the security also appeared on an SRO's list.

If BGI eventually did meet all criteria and became a threshold security, then any clearing firms or market makers with open fails in BGI would be required to proactively purchase or borrow shares to clear those fails within 13 settlement days, and could face restrictions on new short sales if they did not.

Practical Applications

Threshold securities status has several practical implications across financial markets, primarily in the realm of regulatory oversight and trade execution.

For Broker-Dealers: When a security is on the threshold list, broker-dealers must be particularly diligent in ensuring they have proper "locates" (arrangements to borrow) for any short sales in that security. If a broker-dealer has an outstanding failure to deliver in a threshold security that has persisted for 13 consecutive settlement days, they are prohibited from effecting further short sales in that security without pre-borrowing the shares⁷. This directly impacts their securities lending operations.
For Regulators: The threshold list serves as a monitoring tool for the SEC and self-regulatory organizations like FINRA. It helps them identify securities where persistent delivery failures may indicate potential market manipulation, operational issues, or abusive naked short selling⁶. The FINRA website provides detailed information about Regulation SHO and its requirements, underscoring the importance of compliance for member firms⁵.
For Investors: While investors do not directly interact with threshold lists, the existence of such regulations offers an important layer of investor protection. It aims to prevent artificial price depressions that could result from unchecked naked short selling and ensures that shares sold are actually delivered, maintaining the integrity of the stock exchanges.

Limitations and Criticisms

Despite their intended benefits, the regulations surrounding threshold securities and Regulation SHO have faced certain limitations and criticisms:

Complexity and Interpretation: The rules, particularly those related to "bona fide market making" exceptions, can be complex, leading to varying interpretations and potential loopholes⁴. Critics argue that these complexities can be exploited, allowing some instances of abusive short selling to persist.
Effectiveness Debates: While Regulation SHO aims to curb failures to deliver, some market observers suggest that persistent FTDs still occur, and question the full effectiveness of the threshold security mechanism in preventing naked short selling ³. Academic studies have yielded mixed results on the impact of FTDs on market quality and price distortions.
Potential for Market Impact: Some argue that overly stringent short selling rules, including those related to threshold securities, could inadvertently reduce liquidity or hinder legitimate price discovery. By making it harder for investors to execute stock loans and short sales, these regulations could theoretically impede the efficient incorporation of negative information into stock prices.
Data Lag: The publicly available fails-to-deliver data, while important, often has a lag, meaning that a security might be experiencing significant delivery issues before it appears on the threshold list or before the full extent of the issue is transparent to the public².

Threshold Securities vs. Naked Short Selling

While closely related, it is crucial to distinguish between threshold securities and naked short selling.

Threshold Securities refer to a status or designation applied to a particular equity security by regulators. This status is triggered when a security experiences a high volume of persistent failures to deliver over a defined period, meeting specific criteria set forth in Regulation SHO. It is a regulatory consequence designed to flag and address delivery problems in certain stocks.

Naked Short Selling, conversely, is a trading practice where a seller sells shares without first borrowing them or ensuring they can be borrowed, often leading to a failure to deliver on settlement date. It is a specific type of short selling that can contribute significantly to a security being designated as a threshold security. However, not all failures to deliver are a result of naked short selling; they can also arise from legitimate operational issues or delays in the settlement process¹. The threshold security designation is a regulatory response to the symptom (persistent failures to deliver), which naked short selling can be a cause of.

FAQs

Q: What is the primary purpose of designating a security as a threshold security?

A: The primary purpose is to identify securities with significant and persistent failures to deliver and to trigger enhanced close-out requirements for broker-dealers to ensure timely delivery of shares. This helps prevent abusive short selling practices, particularly naked short selling, and maintains market integrity.

Q: How long does a security typically remain on the threshold list?

A: A security remains on the threshold list until it no longer meets the criteria for five consecutive settlement days. This means the aggregate failures to deliver must fall below the defined thresholds (10,000 shares and 0.5% of shares outstanding) and remain there for that period.

Q: Does being a threshold security mean the company is failing?

A: No, being designated a threshold security does not necessarily mean the company itself is failing. It indicates significant issues with the delivery of its shares in the secondary market, which could be due to factors like high short selling interest, operational inefficiencies among broker-dealers, or instances of naked short selling.

Q: Can an individual investor find out if a stock is a threshold security?

A: Yes, self-regulatory organizations (SROs) like NASDAQ and NYSE publish lists of threshold securities. The SEC also provides data on failures to deliver, which can be used to track potential threshold securities. These resources are generally available to the public.