WHAT IS NAKED SHORT SELLING?

Basherbusters.com explains what is naked short selling.

(emphasis mine) [my comment]

What is Naked Short Selling?

Naked short selling (naked shorting) refers to the practice of selling a stock short without first either Borrowing the shares or Making an "affirmative determination" that the shares can be borrowed.

In the United States, the Securities and Exchange Commission issued "Regulation SHO" in an effort to curb abusive naked shorting. Many other countries and trading markets have developed similar regulations.


The Problem
Short selling is a bet that a stock price will decline. A short seller borrows stock and then sells it, hoping to buy back the same amount of stock later, at a lower price, for return to the lender. Short selling is legal.

Naked short selling involves selling stock without first borrowing (or sometimes even locating) the stock [naked short selling = selling imaginary stocks (with the assumption of borrowing stock later to make it real)]. If a naked short seller does not borrow the stock he sold, he will be unable to deliver that stock to the buyer to close the transaction. This is called a “failure to deliver” (FTD) [When a brokerage “fails to deliver”, the imaginary stock ends up staying imaginary, possibly for years]. Naked short selling is generally illegal, though market makers are allowed to temporarily naked short for the sake of bona fide market making. FTDs are always illegal when delivery failure exceeds 13 days.

Exchanges do not disclose whether short sales are naked and supply no information on FTDs. Even worse, in transactions where shares are not delivered, brokerages issue stock IOUs called “share entitlements [This is a nightmare waiting to happen].” Retail customers’ account statements do not distinguish between real shares and share entitlements. [brokerages are adding counterparty risks to their clients stock purchases without their knowledge. This is fraud.]

FTDs create phantom shares that circulate in the system as real shares. Just as counterfeit currency dilutes and destroys value, phantom shares deflate share prices by flooding the market with false supply.

Some short sellers use naked shorting and oversupply of phantom shares to manipulate stock prices downward. Because regulations are loose and enforcement lax, they are unafraid of failing to deliver.

Customers holding phantom shares can, and often do, re-sell those phantom shares as if they were real. Subsequent purchasers do not receive real shares; instead they receive only share entitlements. Phantom shares sold by naked short sellers are thus laundered in the market by subsequent transactions in which share entitlements come to resemble (but cannot become) real shares of stock.


FTDs threaten market integrity in at least three ways

The corporate voting system is undermined by chronic over-voting. The circulation of FTDs leads to more ownership than there are shares to own. As a result, brokers and transfer agents routinely mail out and receive back more proxy votes than there are shares to vote. [As actual data is unavailable, this massive over-voting is the best evidence/proof that naked short selling problem.]

Companies and shareholder value are destroyed

Market integrity is threatened. Large brokerage firms and hedge funds often use leverage to build naked short positions, a strategy that poses systemic risk to financial markets.

What little is publicly known about FTDs is available as a result of Regulation SHO, implemented by the SEC in January, 2005, in order to curb abusive naked short selling and reduce FTDs. Regulation SHO requires exchanges (e.g., NYSE and NASDAQ) to publish daily a list of firms with FTDs above a calculated threshold. That list is known as the Regulation SHO Threshold List.

Since Regulation SHO was enacted two years ago, 4,512 companies have appeared on the Threshold List. According to a recent Office of Economic Analysis report, 6,223 securities have graduated from the Threshold List, meaning thousands of companies have been on the Threshold List more than once. Curiously, Regulation SHO only reports victim companies; there is no disclosure of either the amount of FTDs or of the institutions who fail to deliver. The size of past (but not current) FTDs can only be obtained through petition to the SEC’s Freedom of Information Act (FOIA) office.

Neither the SEC nor the exchanges will disclose the names of the institutions failing to deliver, even through FOIA petition, as “fails statistics of individual firms…is proprietary information and may reflect firms’ trading strategies.” [These “trading strategies” involve blatant fraud. Therefore releasing “fails statistics of individual firms” would obvious affect these “trading strategies”]

The SEC’s prediction


that firms could not remain on the Threshold List longer than 13 days was false:

FOIA data reveals
significant FTDs as a percentage of average volume in select exchanges and issuers:

Regulation SHO “grandfathered” FTDs older than January 2005 and new FTDs prior to an issuer’s appearance on the Threshold List, thus pardoning sales for which money was paid but no stock delivered. [Since FTDs older than January 2005 have been “grandfathered”, they are excluded from all the data disclosed by Depository Trust and Clearing Corporation (DTCC)]

While publicly downplaying the issue, the SEC has quietly admitted to adopting the grandfather clause because of concern about “creating volatility where there were large pre-existing open positions.” [As with gold (and other commodities), brokerages have over the years slowly build up a massive short position in the US stock market. Making them unwind these short positions would cause the US financial system to collapse.]

Scholars have shown that many FTDs are strategic—that is, used to manipulate prices.

Large U.S. brokerages collectively own and operate the Depository Trust and Clearing Corporation (DTCC). The DTCC operates with little SEC oversight and consistently denies the existence of a systemic problem while simultaneously fighting public disclosure of even minimal FTD data.

What little data the DTCC does disclose is misleading. For example, the DTCC claims failed trades sum to $6 billion daily, or 1.5% of the dollar volume.

The true magnitude of FTDs is obscured by Continuous Net Settlement (CNS), which nets failures against shares held by brokers. The DTCC asserts that CNS has “eliminated the need to settle 96% of total obligations.” If the DTCC processes $400 billion in trades daily as claimed, then $384 billion are netted out and only $16 billion require delivery. Thus, the $6 billion in FTDs that exist on any given day is 37.5% of the trades that require delivery—twenty-five times the 1.5% reported by the DTCC.

The statistics above ignore “ex-clearing”—that is, trades cleared directly by brokers bypassing the DTCC. Some scholars believe that “fails occurring through ex-clearing may elude the [reporting] requirements of Regulation SHO.” FTDs in ex-clearing may be four times as great as quantities discussed above. The DTCC’s Stock Borrow Program (SBP) adds additional mystery to the situation.

My reaction: Regulators have allowed US brokerages to turned the stock market into a Ponzi scheme.

1) Brokerages are allowed to sell imaginary stocks to investors, with the assumption of replacing them with real shares later.

2) When brokerages “fail to deliver” and replace imaginary shares with real ones, these brokerages issue stock IOUs called "share entitlements.”

3) Exchanges do not disclose whether short sales are naked and supply no information on FTDs.

4) Retail customers' account statements do not distinguish between real shares and share entitlements.

5) Share entitlements created by FTDs circulate in the system as real shares, flooding the market with false supply. Companies and shareholder value are destroyed.

6) Large US brokerages collectively own and operate the Depository Trust and Clearing Corporation (DTCC). The DTCC is the primary vehicle for enabling naked short selling.

7) What little information available about FTDs comes from the DTCC, and these discloses are misleading:

A) FTDs older than January 2005 have been "grandfathered" and are excluded from DTCC disclosures.
B) Continuous Net Settlement (CNS), which nets failures against shares held by brokers and obscures the true magnitude of FTDs.
C) DTCC statistics ignore "ex-clearing” data (trades cleared directly by brokers bypassing the DTCC).
D) The DTCC's Stock Borrow Program (SBP), which allows brokers to borrow nonexistent shares, reducing FTDs.

8) Widespread, chronic over-voting offers the most telling evidence of the “stock IOUs” floating around the financial system.


Conclusion: While I am disgusted that brokerages use naked short selling to manipulate the stock market, it is not what worries me about naked short selling. The two issues I have with naked short selling are:

1) “Share entitlements” creates a counterparty risk that investors are completely oblivious to. For example, lets an investor named Jon is worried about the dollar collapse, and, to protect himself he buys $500,000 of gold mining stocks through JPMorgan. Jon relaxes, thinking his investment in gold stocks will protect him from a currency collapses. However, when the dollar does collapse, JPMorgan goes under, and Jon finds out he actually owns 500,000 of “share entitlements” to gold mining stocks, not the stocks themselves. This makes him a general creditor in JPMorgan’s bankruptcy. Months later, after much litigation, Jon is able to recover $100,000 of his initially investment. Unfortunately for Jon, the dollar has already lost so much money that this 100,000 won’t even buy a pack of gum.

While this is an extreme example, it illustrates how naked short selling has added counterparty risks to owning stocks.

2) Brokerages are selling billions, if not trillions, of imaginary assets. These imaginary stocks sales (and associated fees) are responsible for a large portion of the financial “profits” used to justify huge banker bonuses. The proceeds from these imaginary stocks sales also help pay these huge bonuses or any other purpose these institutions see fit. This is simply ridiculous: the sale of imaginary assets can't be the basis of a viable financial system.

Brokerages are supposed to be middle men for their clients. When investors turn over cash for the purchase of a stock, brokerages are supposed to use this money to secure the actual share. Instead of doing so, brokerages are putting “stock IOUs” into their clients account instead. This is even worse than the deposit reclassification scheme banks use with their client’s checking account.


Final note: See why I like physical gold now? In a financial system overflowing with “imaginary shares” and “stock IOUs”, owning any asset via a brokerage firm, even a regular stock share, has counterparty risks.

Eric de Carbonnel

Market Skeptics

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