Naked Shorts

More than fifteen countries have banned or restricted short selling in some way since the beginning of the credit crisis. Shorts are seen as vultures and immorally benefiting from somebody else’s misfortune. Shorts play an important role to keep markets efficient however, that is if they don’t engage in illegal or manipulative activities.

It has become clear that numerous companies took too much risk by taking on highly leveraged products they didn’t understand and because of that failed  to manage those risk properly. Short sellers, who in their conviction of profiting from mismanaged companies or overvalued products, put theirown money on the line. That’s not only a right in a free society but it’s also a usefull task. It guarantees that a market can’t be as easiliy manipulated by a handull of longholders and helps find the equilibrium in a free market more quickly and more efficiently. So really, honest short players should have been applauded for their actions over the past few months. Their strong conviction to bet against financials for exampe could have be seen by many as a strong warning that something was seriously wrong. Of course nobody realy bothered.

Nevertheless short players can get into harmful actions as well. Naked shorting, selling shorts instruments that were not borrowed, is a potential massive problem. These trades lead to a Failure To Deliver (FTD) and in essence bring more stocks into circulation than were issued by the company. A bit like a printing press for stocks (see here for more background). The Depositary Trust & Clearing Cooperation (DTCC) denies that those naked shorts are of any significance, despite several lawsuits against DTCC on this subject as well as actions from the SEC to prevent naked shorting getting out of control.

Patrick Byrne made a good argument though that whatever data DTCC is basing itself on, it is probably grossly understated, as shown by the following hypothetical Goldman and Morgan examples:

• “Desked trades” – Imagine Goldman takes your order for 1,000 shares of stock, but stashes your order in a desk and sends you statements saying that you have those 1,000 shares in your account (and use your money towards the $10 billion they pay themselves at the end of the year for being so clever). They have written a CDF to you without your knowledge: there is a 1,000 share failure-to-deliver to you at Goldman (which no one else knows about, incidentally).

• “Pre-netting” – Goldman has one client sell 5,000 shares and another buys 3,000. The seller never delivers. Goldman “pre-nets” the trades before submitting them to the DTCC. Hence, the DTCC sees only 2,000 shares of the failure.

• “CNS netting” – Goldman submits to the DTCC’s Continuous Net Settlement system that it sold 2,000 shares that it does not deliver. Imagine Morgan Stanley was on the other side of that particular trade. But maybe Morgan has a client who sold 1,000 to a Goldman client, and which that Morgan client failed-to-deliver. The DTCC nets the two trades, and therefore sees just 1,000 shares of failure (Goldman to Morgan).

• “Stock Borrow Program” (“SBP”) – The DTCC looks at that 1,000 share failure, and says, “We have 400 shares we can loan Goldman from our Stock Borrow Program”, i.e., from the accounts of other BD’s within the DTCC. That reduces the failures it sees to 600.

• “Ex-clearing” – Suppose Goldman and Morgan apply to the DTCC to move 500 of those fails ex-clearing, and the DTCC approves. Those 500 FTD’s are turned into a derivative contract between Goldman and Morgan. As a private contract, it is not regulated by the SEC, and the DTCC does not even know when that contract gets cleaned up, if ever.

• “Offshore Failures” – Suppose someone sells 1,000 shares into this market from a foreign offshore exchange? There is a different terminology to describe such failures, and therefore the data is hard to get to. What is clear, however, is that there is little pressure to clean up failures among exchanges.

It seems that preventing naked shorting is rather simple: don’t allow any failed trades beyond the usual settlement term and follow up with buy-ins if necessary. Nevertheless the above example shows that things might not be that simple as the bulk of the naked shorts might be on the books of the investment banks, instead of within the DTCC system. Especially when the naked shorting occurred in very liquid house hold names.

So that leads to an interesting question: when are we going to have the first stock counterfeiting lawsuit or class action  against the investment banks?