Naked Short Selling / Failing to Deliver
Naked short selling occurs when a seller sells a share of stock, and then fails to deliver it.
In a legitimate short sale, the seller first borrows a share of stock, and THEN sells it, hoping to buy it at a lower price before he returns it to the lender, his profit being the difference between the sale price, and his later buy price. It is a bet on a price decline, and legal as described. Sell high, buy low.
A naked short sale is a manipulative trading technique. It takes advantage of a structural deficiency in the system that allows a transaction to occur, and all moneys to be paid, before delivery occurs.
So a transaction goes by on the tape - a sale - and it is processed, and has an effect on the price of the stock, but the delivery portion of the transaction is left for days later. Meanwhile, the depressive effect of thousands of these sales extracts it toll on the price - the naked sales are still sales, and are treated as legitimate by the system.
At some point after the checks have been cashed and the commissions distributed and the fees paid, the share never shows up.
Illegal In Most Instances
Naked short selling is illegal as described - it can be legal in certain limited circumstances: for a market maker that needs to provide shares in a fast moving market for a thinly traded security, but in that instance it will buy the share back a few cents below where it sold it - Sell at $4.20, buy at $4,00 - which is part of legitimate market making. Or an options market maker will do so to hedge its sale of put options. These are legal, limited-time frame exceptions. All other instances are illegal.
The industry term for a naked short sale is a Fail to Deliver (FTD), because the seller fails to deliver.
The FTD is handled by the clearing and settlement system (the DTCC, a for-profit company wholly owned by Wall Street - the brokers) in two ways:
1) The stock borrow program at the NSCC (a subsidiary of the DTCC) enables that entity to borrow shares from an anonymous pool, and effect delivery to the buyer. The NSCC then creates a debit in the seller's account, and holds the cash from the sale (minus commissions, of course) as collateral. It charges a fee to do that, and the program was designed to accommodate "temporary" delivery failures - but has been abused over the years, as "temporary" has no fixed definition, and some unscrupulous hedge funds think "temporary" means years.
2) The non-CNS (Continuous Net Settlement) system, or ex-clearing (ex- meaning outside of) system, which allows the NSCC to handle the cash for the brokers and pay everyone, but leaves the delivery portion of the transaction outside of the system, between the two brokers, on the honor system. The brokers ALL have a ledger in their back offices where they keep track of the IOU's from each other, and this has resulted over time in a ghost, or phantom, float of electronic book entries in the system, with no stock existent to support the transactions - just IOU's.
The DTCC reports that the FTD problem amounts to $6 billion a day, marked to market. It is unclear whether that includes the ex-clearing transactions or not - the language used is ambiguous, and allows for different interpretations. Many have asked for clarification, and none has been offered - the DTCC doesn't like to talk about this, to anyone, including the regulators.
Critics of the DTCC charge that the Stock Borrow Program creates more book entries/FTD's/IOU's than there are shares of stock issued, which the DTCC has denied in carefully parsed language that actually doesn't deny the direct accusation. These critics maintain that the lending pool is replenished as shares are borrowed, delivered to the buyer's broker, then put right back into the pool by the new broker to be lent out again, thereby giving birth to IOU after IOU. The DTCC carefully argues that it never lends more shares than there are in customer accounts. This is technically true, as Lender A's account has no share in it once it is lent to Buyer B, but when Buyer B re-deposits the lent share into his DTCC account, available for loan, it then gets lent to Buyer C, leaving a nice little trail of IOU's as it worms its way through the system. The DTCC never addresses this, and instead answers questions that weren't asked, in the best tradition of politicians and bureaucrats everywhere.
The DTCC has said that only 20% of the transactions are handled via the Stock Borrow Program. That leaves the question of how the remaining 80% are handled. The answer is via the ex-clearing system.
How can the SEC allow this chronic failure to deliver to occur, creating a de facto phantom float of book entries/IOU's with no shares to support them? Aren't those in actuality counterfeit shares, falsely represented to the buyers as real? If they are treated by the system as equivalent to genuine shares for the purpose of creating a transaction, I would argue they are.
The system tells the buyer that all is well, and doesn't differentiate between a legitimately delivered share and an IOU. Thus, the buyer sees that he bought 1000 shares of ABC on his brokerage statement or on his screen - but there is no way of knowing how many are real shares and how many are IOU's without obtaining paper certificates, which cannot be counterfeited with the ease of an electronic book entry/tick/IOU. The brokers will tell you that of course there's shares there, or alternatively, that it is a non-issue, as the ticks can be sold at any time, getting the buyer's cash out of the trade. These explanations deliberately ignore that there is no attendant share to back up the IOU.
A share is a specific thing, a parcel of rights, from the issuing company. Among these rights are the right to vote, and the right to legal redress (you can sue them as an owner of the company), and the right to any dividends, cash or stock.
An electronic book entry without a share to back it up has none of these rights.
The lack of differentiation between real shares and IOU's has resulted in a market where we are trading claims on shares, rather than genuine shares, and oftentimes there are many more claims than there are shares. That is not the way the market is supposed to work.
Systemic Problem of Critical Scope - Rule 17A Sought to Prevent This
Congress mandated in Rule 17A of the 1934 Securities Exchange Act that our markets have prompt, accurate clearance and delivery. It reads, "The prompt and accurate clearance and settlement of securities transactions, including the transfer of record ownership and the safeguarding of securities and funds related thereto, are necessary for the protection of investors and persons facilitating transactions by and acting on behalf of investors.”
That seems pretty clear. BOTH clearing (booking the sale and paying for it) and settling (delivery) need to happen promptly, and further, the transfer of record ownership needs to occur. The rule makers understood the temptation to come up with a way to game this, so were clear on the necessary predicates. Clear AND Settle, including transfer of ownership.
FTD's violate that mandate. No record ownership is transferred on a stock share via an IOU. Further, none is transferred via a Stock Borrow Program "loaned" share - because if it were, then the lender would lose his ownership, which would be a sale, not a loan - so either the "loan" is a disguised sale in which record ownership IS transferred, in which case the NSCC appears to be deliberately disguising a sale by erroneously calling it a loan, or no record ownership is being transferred, in which case it violates 17A. Those are the only two choices. Neither is pretty, nor legal.
So how does the SEC allow this to go on?
They typically cite Addendum C of the NSCC's rules, which allows for the stock borrow program to loan stock to cover TEMPORARY settlement failures - the kind resulting from lost certificates. The "temporary" caveat has been ignored, and it has instead become a long-term device to create an unlimited number of electronic book entries.
They also take the position that the ex-clearing transactions are the province of contract law, as the agreements to deliver are a contractual agreement, and the SEC doesn't mediate contractual disputes. A nice way to step out of the role of regulator of the markets, and create instant deniability. The NSCC takes the same position, leaving things up to the brokers, on the honor system.
So the back offices create an unknown number of IOU's, predictably resulting in depressed prices for the afflicted securities, and the regulators say it isn't any of their business.
Systemic Risk
Because of this unbridled FTD manufacturing, a tremendous contingent liability for the industry has been created over time, as the large float of FTD's represents stock that needs to be bought back at some point in the future, but for which there is no guarantee that stock is readily available. In some instances there are reports of companies where FTD's represent multiples of the issued genuine shares.
The collateral used to secure the FTD at the NSCC is cash, but it is marked to market against the price of the stock at the end of the day, and any overage is available to the seller. This means that if the FTD was created at $20 per share, and the stock has been run down to $5 per share, the seller gets to withdraw the $15 dollar difference. This creates a dangerous situation where the system is hopelessly under-collateralized for the true risk - the shares will cost far more than their current depressed price to cover, as the depressed price is often a function of massive selling of FTD's. This is the contingent liability risk. It is likely considerable, and is ignored by the system.
This risk creates a situation where the brokerage community has a vested interest in seeing the prices of victim companies stay down once they are down, as their best customers (hedge funds) have taken out the over-collateralization dollars over the years from the FTD's, and used them to collateralize other securities - many times, more FTD's.
The most obvious way to keep the price depressed and enable everyone to continue to make money is to issue more FTD's whenever the price of a victim security starts to rise. This creates a self-fulfilling prophecy of chronic price manipulation via the issuance of FTD's.
It is likely that there is a severe leverage crisis with the hedge funds that use FTD's, as they have used borrowed funds to collateralize the initial FTD, and then used the over-collateralization to create yet more FTD's. If one of these funds was to unwind it could vaporize the assets of the fund involved virtually overnight, and create yet more systemic problems for other hedge funds as their positions rise in value, triggering more de-leveraging.
It is the classic derivative risk de-leveraging scenario wherein one or two larger funds can cause a meltdown, a la Long Term Capital Management (LTCM) in 1998, where one highly leveraged hedge fund with $2.2 billion in assets caused the entire US credit markets to shut down. LTCM was not naked short selling - they are mentioned to illustrate how one leveraged fund can endanger an entire market.
The SEC is likely aware of this risk, as it heretofore inexplicably violated SEC Rule 17A, and grandfathered in all FTD's prior to 2005, even though long term FTD's were illegal for many years prior to that date, and even though it is in violation of their Congressional mandate. Further, and perhaps more disturbing, the grandfathering rules grandfathers current FTD's below the threshold once a stock hits the Reg SHO Threshold list - market manipulators still get one free bite of the apple even on new SHO entrants - all the fails up until the company lands on the list are inexplicably grandfathered as well, even if they happened today. Wild? It's fact.
SEC Forgives Past Larceny With No Penalty - Why?
Why would the SEC grandfather all prior fails, as well as current fails below the threshold, and knowingly violate their Congressional mandate? It is akin to allowing bank robbers keep the proceeds of all prior bank robberies. There are two logical explanations available to us:
1) The SEC knows about the systemic risk FTD's cause, it is terrified of the implications, and it wanted to, at the stroke of a pen, eliminate that risk from the system, even if it violated the law and was at the expense of shareholders who had been financially decimated by the practice.
A choice was made to allow the brokers and hedge funds to keep the proceeds of their ill-gotten gains, and not require them to ever buy in the shares they had printed whole cloth.
The SEC admits it, in their own bureaucrat-ese. From the February, 2005 Euromoney article on the controversy:
The SEC's Brigagliano says the commission made a choice. "We were concerned about generating volatility where there were large pre-existing open positions, and we wanted to start afresh with new regulation, not re-write history."
Substitute the words "not enforce existing, decade-old laws" for "not re-write history" and you have the plain English version. The SEC violated 17A, knowingly, because they were worried about causing "volatility" - SEC-speak for short squeezes, where stocks with millions of FTD's go through the roof as they are bought in - essentially a return of capital to those damaged by the FTD's, as their cash is returned to them, in return for selling their genuine shares. That would be the fair way equitable markets would work - those who had made untold billions using FTD's would have to pay most or all of it back in short squeezes, as legitimate supply and demand are returned to an unbalanced market (because of the current artificial supply of FTD's).
The SEC was apparently so concerned about that "volatility", that their solution was to give the violators a free pass, and allow the damaged shareholders and companies to remain damaged in perpetuity, never settling nor having record ownership transferred. This decision underscores the likelihood that the SEC understands the systemic risk years of FTD creation have created, and will go to great lengths to avoid triggering an event that would cause the violators to have to settle the trades.
A more cynical interpretation is that the SEC didn't want to cause undue financial hardship for the more politically and financially important violators (the violators would likely be both, as they had years of selling non-existent shares with which to build and solidify their financial importance - and to spread the wealth by supporting their elected officials with contributions), choosing instead to lock in the industry's illegally generated profits, rather than have the violators pay it back - the SEC favored the hedge funds and brokers that had violated the law, over the shareholders and companies that had been brutalized by the practice.
2) The far more ominous logical explanation is that the SEC grandfathered not out of concern for the system, but rather to limit its own liability under the law - that after years of permitting felony short selling/securities fraud manipulation, the SEC ultimately came to realize that it had committed collateral crimes, and could be held accountable - as accessories to the felonies. This explanation posits that in passing Regulation SHO, the SEC wasn’t just grandfathering the previous illegal short selling to protect the short sellers, but rather it was, much more importantly, protecting the SEC itself. And it focused the ire of the victims on the rule violators who financially benefitted, rather than upon the regulator that had permitted the felonious activity for years.
The legal argument would go like this (simplified): The felony committed and suborned in this situation is USC 18, Title 514, the commission of counterfeiting of a commercial security, a Class B Federal Felony. By permitting this felony to be an endemic part of the modern market system, and by knowingly failing to enforce rules designed to prevent counterfeiting of a commercial security, the SEC aided and abetted those who have done so, subjecting it to risk of civil and criminal redress. The permission of a large float of FTD's to be part of the markets is a de facto permission of counterfeiting (wherein the bogus IOU/Markers are represented as and have the effect of legitimate stock shares, on the auction price of the security as well as on the long term size of the float), and thus creates an accessory risk for the Commission. Arguments have been advanced that, as in the Elgindy case, naked short selling was used for money laundering for Middle Eastern arms dealers, thus constituting treason during a time of war (according to the Patriot Act), a Class A Felony - that the Commission was ignorant of the outcome of its permitting the counterfeiting does not absolve it of the legal jeopardy arising from that outcome, any more than the driver of a getaway car in a bank robbery is absolved of the murder of a teller during the robbery - even though he was ignorant of the ultimate crime committed. That is not how the law works.
Note that I take no position as to the likelihood of this second explanation being correct. It is a credible explanation advanced by several experts familiar with the legal ramifications of allowing FTD's to remain in the system in perpetuity, and failing to enforce rules designed to stop larcenous action, nothing more.
FWIW, it is far more likely that the SEC folks understand that upon retirement they will receive $700 per hour jobs with top lawfirms representing Wall Street, and that knowing this they are much more likely to favor Wall Street's interests. Most agencies of the Government have the conceit that comes from unbridled power, and it is hard to imagine Federal employees actually afraid of liability for anything. Thus, the second explanation is a hard one to swallow.
But whatever the motivation, charitable or cynical, you arrive at the same effective point: Years of lawless predation were pardoned (in violation of 17A's Congressional mandate), the profits kept by the criminals, with no penalty or sanctions imposed - leaving investors and the victimized companies out of luck, and money.
So what about now?
Since the new FTD rule was passed (Regulation SHO, for SHOrt) and went into effect January, 2005, more companies have gone onto the Threshold list (a list of companies whose FTD's exceed a "threshold" of 10,000 shares AND 1/2% of their total issued shares), and more FTD's have been created. The industry can't help itself (and truthfully why would they?) - it is just too lucrative to ignore the un-enforced rules, and continue to manufacture IOU's. The systemic risk continues to build, and the regulators that hoped the industry would heal itself are left unwilling or unable to act - the imperative to create fair markets is clearly subordinate to pandering to the financial well being of the violators.
The DTCC and the SEC take the position that information about this crisis is proprietary and secret, and that our elected officials and companies and we shareholders have no need or right to know the true parameters of the problem. The workings of the machine are opaque, and transparency is derided as an unnecessary invasion of the industry's privacy.
Again, the charitable explanation for this stance is because they want to avoid a potentially damaging meltdown (albeit of their own creation). The cynical explanation is that investors would riot in the streets or abandon the market if they understood what was being done to them, and would hold the SEC accountable for their role in it. Regardless of the explanation that one feels best explains the SEC and the DTCC's actions, what is unarguable is that the size, scope, and ongoing treatment of the crisis is top secret.
This is very much like the way the regulators handled the S&L crisis, allowing a large systemic problem to develop into a catastrophic systemic problem that wound up costing hundreds of billions of dollars, and every man, woman and child in the US about $2K in taxes. We are still paying for it today.
In that episode, the S&L's accounted for about a third of all the business Wall Street did in the 80's, and every big house stuffed the most larcenous of the S&L's with untold billions of junk bonds and options and precarious loans, knowing and understanding that the American taxpayer would ultimately have to pay the freight via secured deposits. Wall Street was assisted in this wholesale looting of the financial system by every major accounting firm in existence, and the most prominent attorneys in the country. Fraud of a mind boggling scale was perpetrated and perpetuated by that industry, and one of the primary beneficiaries was Wall Street, who that time also got to keep the money, laying off the blame on the S&L's. This time around we have hedge funds comprising over 50% of Wall Street's action, and we as a nation seem to have learned nothing from our prior fleecing. One can't understand that catastrophe and not draw striking parallels to this situation.
In fact, the entire FTD crisis is very similar to the S&L crisis, in the sense that staggering amounts of money are in play, private interests are operating in an unregulated environment (hedge funds and ex-clearing), leverage is being employed to compound the risk, Wall Street wunderkind are making preposterous profits, phenomenally wealthy players are receiving preferential treatment even as they knowingly violate the law, Greenspan is saying that no restrictive regulation is required, the industry is protesting that there is no problem, and the entire affair is taking place shrouded in secrecy.
That didn't end well.
The above is simplified, and is conceptual, as in reality there is no single share followed through the system - there are debits and credits to participant accounts at the NSCC, which are netted against total long positions, further obfuscating the mechanisms. But the fundamentals are accurate, if lacking in a certain specificity that could fill volumes. Hopefully it is enough for the reader to grasp the issue and the scope thereof.
* From "Symphony of Greed - Financial Terrorism and Super-Crime on Wall Street", by Bob O'Brien, in progress. Interested literary agents or publishers are encouraged to contact Bob at NCANS.mgr@gmail.com