NCANS FAQ

These are a few of the questions that come up frequently when discussing Naked Short Selling/Failing To Deliver.

What is Naked Short Selling?

Naked short selling (naked shorting), or “Failing To Deliver”, is where shares of stock are sold short but never borrowed and delivered, in violation of the rules on the books for 71 years.

Legal short selling is where stock is sold in the expectation that the price will decline, and can be bought later at a lower price—a bet on a price drop.

Sell high, and then buy low.

And in the meantime borrow shares to satisfy the delivery required to provide the buyer the stock. When the short "covers" (buys stock in the market), the stock he bought is returned to the lender of the original borrowed shares. If he covers at a lower price than he sold the shares for, there is a profit—at a higher price, a loss. The opposite of when you buy a stock and then later sell it (you hope it goes up)—the short hopes it goes down.

The short seller keeps the spread between the sale price and the later purchase price—the profit margin, if you will. In a legitimate short sale, an affirmative determination is made that shares are available to borrow, and then after the short sale, shares are borrowed to supply the buyer of the shorted stock with the expected product—the stock certificate. That’s a legitimate and legal short sale. In a naked short sale, no stock is available to be borrowed or the short seller just has no intentions of borrowing the stock. No shares are ever delivered. It is akin to counterfeiting, or just plain old fraud—something is sold and never delivered - hence the term "Fail To Deliver."

How Does the Fail To Deliver Mechanism Work?

We've created an order flow graph with an explanation to help you visualize the flow of the transaction. In essence, the NSCC is the contra party in each leg of the transaction, and facilitates the process. The fail to deliver part in this diagram resides between the Naked Seller and the NSCC—until the Naked Seller delivers a share to the DTC and closes out the Fail/IOU, there is a Fail To Deliver on the NSCC's books. Additionally, there can be failures to deliver at the delivery side from the buyer's broker to the buyer, before it goes into the clearing system - often times they will hold the orders at the trading desk and fail there for a while - all the time debiting the retail buyer's account immediately for the share purchased, and making money on the float of the $ until they are forced to go buy the shares.

Why Aren’t the SEC or the DTCC or the Exchanges Enforcing the Rules?

There are tremendous financial drivers in place to keep the problem swept under the rug, and simply ignore the damage to thousands of companies and millions of shareholders. The alternative is for those who make large political contributions and have spent years on Wall Street to have to pay their bill—and they have no inclination to do so. Why would they? The system and the regulators have allowed them to get away with Failing To Deliver for years without doing anything, and now the threat is a toothless regulation that nobody is enforcing anyway, that lets them keep the billions of dollars gained by all the Fail To Deliver shares up until Jan., 2005.

You can see why nobody on Wall Street is particularly concerned. Business as usual, with a compliant SEC allowing wholesale looting of the financial system by those with power and privilege. The SEC will tell you that there's no fraud or abuse going on—that the Reg SHO list has alternative explanations than illegal Failing To Deliver. They ignore that those possible explanations in fact don't apply to any of the companies in question—after all, they could apply in a theoretical world, so there's plausible deniability for not enforcing the rules.

The SEC is afraid to act. They know that they’ve allowed the criminals to run the prison, and that in a few more years if they don’t do anything the implosion on the Street will make the S&L crisis look like a trip to Club Med. So they have passed Reg SHO hoping that the Street will police their own and fix the problem, or at least sanitize it. Except those drunk on easy money and boundless power have no interest in killing their livelihoods. So the self enforcement isn't working. As evidenced by the list.

How Can This Be?

The Depository Trust Clearing Corporation (DTCC) is chartered with clearing every stock trade in the US. It is a private entity chartered under the banking laws of New York, and is partially owned by the NYSE and the NASD. Part of its revenue comes from something called a “stock borrow program.” The program is designed to help smooth legitimate delays in delivering stock, such as if the shares are restricted in some way and can’t be immediately delivered, or if there’s a legitimate problem.

What has happened is that some unscrupulous hedge funds have abused the system, and routinely “Fail To Deliver” the stock that they sold short—essentially naked shorting, often from offshore accounts created for that express purpose. The DTCC, in an effort to accommodate, has turned a blind eye and lent them shares out of the pool of shares they hold as part of the clearing process. And the DTCC collects a fee. So there is a financial incentive to look the other way. And the SEC receives a portion of the fee, so one might say that there isn’t much incentive to put a stop to the abuse.

Who Is Doing The Lion's Share of This?

The hedge fund industry has mushroomed over the last decade, controlling hundreds of billions of dollars and wielding enormous clout. Hedge funds are now the largest customers of the big brokerage houses, so they enjoy special privileges and latitude unimagined a few years ago. Interestingly, many of the funds have offshore entities that they control, or simply are domiciled offshore away from prying eyes. Nobody asks them where all the money comes from—even in the US, if you are a hedge fund and open a brokerage account, the broker won't ask where the money came from—it's hedge fund money! So you have a natural fit for illegally generated money to be laundered, in the last unregulated centi-billion dollar environment in the world.

Not surprisingly, hedge funds are the biggest violators of the Fail To Deliver provisions. They use loopholes for international entities to Fail To Deliver from those entities, and are adept at finding ways to game the system. Click here for an example of how one hedge fund allegedly is short more than 30% of the US companies on the NYSE the Reg SHO list, and about 20% of the NASDAQ list. So one group or network is almost a quarter of the problem, if this is to be believed. What a system.

What Can Be Done?

The SEC has to bite the bullet, and rather than being apologists for the few hundred guys on Wall Street who are robbing the system of billions, needs to do its job. It is not like Failing To Deliver isn't illegal, or that it hasn't been for 71 years. Our forefathers understood the threat that naked shorting posed when they created the SEC, and created very specific rules for timely delivery of shares. They had just witnessed the kind of damage that could be done in the 1929 Crash, and wanted to make sure that could never happen again. This is a regulatory issue, and the solution is simple—the SEC needs to enforce the rules, and rescind the provision of Reg SHO that grandfathers in all the violations up until January 7, 2005. There is simply no good reason for letting the hedge funds keep the money that they made by breaking the law, at the expense of shareholders and companies.

The only reasons we have heard for keeping the grandfathering provisions in place are that a lot of hedge funds could blow up if they were forced to cover their fraudulent positions. Well, that's not a very good reason. Nobody is telling the investors that bought the fraudulently issued shares that they don't have to pay for them, or returning the money to them that was paid for counterfeit shares. If some hedge funds will go belly up because they have been the beneficiaries of windfalls from violating the rules, then so be it. Those are the breaks. Crime shouldn't pay—and the idea that we should grandfather in previous crimes as it would be a hardship for the criminals to comply with the law is repugnant, and morally reprehensible.

By supporting NCANS with donations and by keeping the pressure on our politicians, this problem can be solved. For resources on Government contacts, click here. It is one of those rare problems that can be solved immediately, easily, and with no cost except to those who have benefited by violating the rules. There is no good reason to let this go on any longer. If the President thinks it's a good idea to put Social Security dollars into the market, then there better be some assurance that the market is not a lawless money generation device for those who violate the system's basic and reasonable rules.