Understanding Naked Shorting Stock Manipulation

Editor: patrickbyrne

This guide will enable you to understand the growing scandal of naked shorting and how it systematically corrupts our stock markets.

Introduction

The Normal Settlement Process

All shares are held in a central depository - a bank vault, if you will. That vault is called the DTC. No shares ever move around, they always stay in the vault, but a ledger that keeps track of who owns what is updated daily. When someone sells you shares, the seller's broker's account is updated to show ownership of his shares in the ledger moving to your broker.

As far as payment (the cash) goes, a separate office (NSCC), think of it as the bank front office, takes your money and credits it to the seller. So it's simple - the front office alerts the vault that your money has hit, and the ledger is updated to show the shares being credited over to you.

The Settlement Process with Failures

In a failed delivery, your money hits the front office, but there are no shares to credit over. But the ledger is updated anyway, with an IOU entry made versus a transfer. The system trades and treats the IOU the same as if you got real shares, only you didn't. The net effect on TRADING is an inflation of the shares available for trading, exactly the same as if the seller had counterfeited stock and slipped it into the vault. Because there is no practical limitation on creating IOUs, there is no limitation on creating apparent supply of "stock."

In legal short selling, the seller borrows some of the shares in the vault from the legitimate owner's broker, and then uses those to make good on his short sale when it comes time to credit shares over to you. In naked short selling, no shares are borrowed. The system just creates an IOU, which you are never told about.

You got nothing but an IOU, in exchange for your real money. And you are never told.

The problem is that because there are different levels all those IOUs can be created at, nobody is sure how many IOUs are trading versus real shares. That destroys the integrity of the market, as there is no linkage between supply and demand.

As far as netting goes, netting is just the reconciliation of the ledger every day. It's easier, if broker A owes broker B 500 shares of IBM for Harry hedge fund, but broker B owes broker A 400 shares of IBM from a different hedge fund, to simply update the ledger so it shows 100 shares owed after all is said and done. 900 shares have actually transacted as sales, but it "nets" to only 100 at the end of the day. If all 900 fail to deliver, only 100 will show up after netting, as the system doesn't differentiate between delivered shares and undelivered.

The Kinds of Failures and Where they Accumulate

Delivery failures happen at different levels of the system. As described above, they happen at the bank vault level - at the DTC's ledger. That is the classic "FTD" (Failure To Deliver) you hear about when the SEC and the DTCC (Depository Trust Clearing Corporation - privately held clearing monopoly owned by the exchanges and brokers/banks) are discussing the issue. They also happen "pre-netting", which means before the information goes to the DTC and NSCC. That is at the broker level, or the clearing house level. In that instance, the broker may have a customer who buys 1000 shares of IBM, and a hedge fund who short sells 1100 shares but doesn't have any shares to deliver. The broker takes both orders, and nets the buys against the sells at the broker level, in-house, for a total FTD to the DTC of 100 shares. The others are netted in-house, or ?pre-netting."

Same thing happens at the "clearing house" level, where most smaller brokers clear their trades through before the info is sent to the DTC: the clearing house gets 1 million sells of IBM today, and 980 thousand buys, and regardless of delivery, nets them, for a total FTD to the DTC of 20 thousand FTDs.

That's why "pre-netting" masks the level of the problem by an unknown, but presumably large, amount.

After pre-netting, the info goes into the CNS system (Continuous Net Settlement) and gets netted again, this time sales netted against shares held long by the brokers (at the DTC). In this case, those 20 thousand FTDs that are the end result of 1 million FTDs at the broker level, are netted against the 5 million shares held by the broker or clearing house, at the DTC, resulting in NO FTDs in the system. It is only once all the shares held long by the broker are offset by sales, DELIVERED OR NOT, that the first FTD makes its way out into the open. So, many days' volume of FTDs into the CNS system occur and then finally, the first FTDs hit, "post-CNS netting."

"Ex-clearing" is a term used for transactions arranged outside of the DTC system - "ex" the conventional DTC clearing system. In ex-clearing, the brokers could have millions of shares of IBM they sold that don't exist, but they settle the transaction outside of the system, wherein the money changes hands via the NSCC as in the above instance, but the share settlement - the delivery - happens ex-clearing, which can mean, never. Nobody knows, as it is viewed by the DTCC and the SEC as a contractual arrangement between adults, and they take the position that whether or not the shares ever deliver is a contractual matter, not a stock trade matter of concern to those organizations. Ex-clearing accounts for another large, but unknown number, of FTDs.

International trades cleared through international clearing houses can also FTD, and can be netted behind the international clearing house curtain. In that instance, a hedge fund in Bermuda could trade all day via an international broker using one of the unregulated electronic exchanges, and at the end of the day, all the buys and sells in that international arena can be netted against each other, so even after huge trading volume, few or no FTDs are reported to the US-based DTC.

Again, in netting, as long as the buys cancel out the sells, regardless of the amount of trading and the effect that trading has on the stock price, at the end of the session it is as though nothing happened if everything nets out. Of course, the end of the session could have a stock price that is 20% lower than at the start, however netting doesn't concern iteself with that. There could have been millions of trades with no delivery, but as long as an equal number of buys went through the same international clearing house, they will net out. This promotes trading between related international accounts, to manipulate the price while hiding behind the international clearing houses.

How Many Failures Are There?

Nobody knows how many delivery failures exist, because nobody knows the totals of all the above types of failures. The Securities Industry and Financial Markets Association(SIFMA) publishes a spreadsheet representing only the NYSE member brokerage firms, where the Q3, 2006 totals of delivery and receipt failures for the last day of that period was $55 billion dollars. That would likely be the pre-CNS netting number, which reconciles nicely with the DTCC's statement that CNS netting "handles" 96% of all trades. If that is the case, then logically the remaining 4% of all trades aren't handled via netting.

The SEC and DTCC use the number $6 billion of delivery and receipt failures per day. If they are choosing a post-CNS-netting number, that would be about 96% lower than the pre-CNS-netting number, or a little over 10 times less. 10 times less than $55 billion would be around $6 billion or so, consistent with this interpretation,

So when anyone in the industry assures us that the problem isn't a large one, a fair question is, "How do you know what you claim to know?" Ex-clearing totals are not available, nor are pre-netting nor international netted totals, so it's anyone's guess. However what we can see, from the SIFMA spreadsheet and the DTCC's own statements, is ominous enough to contradict the position that this is a small problem.

The Effect on Companies

Publicly-traded companies are the only ones authorized, under the Securities Act of 1933, to issue stock in those same companies. This is to preserve the integrity of those companies' stock, and its attendant parcel of rights, including the right to vote, and the right to receive dividends. When delivery failures are allowed to trade alongside legitimately registered and issued stock, it destroys the integrity of the market system and any understanding of value based upon supply and demand. It also damages the company issuing the legitimate stock, as that stock is its currency, to be used for compensation, acquisitions, collateral for debt, capital raises, etc. When the price of stock is depressed artificially due to FTDs increasing supply in the face of fixed or limited demand, the value of the company's currency is depressed. This harms the company, as well as shareholders in the company, in precisely the same way counterfeiting does.

Bloomberg TV recently had a 30 minute special on naked short selling and its destructive impact on companies targeted by stock manipulators, that highlighted some of the companies devastated by the practice.

The Regulatory Response

The SEC passed Reg SHO, for SHOrt selling, in 2004, effective January, 2005. This rule created a "threshold list" of securities for which there were delivery failures above a threshold: 10K shares AND .5% of the total outstanding shares. As part of that rule, it also "grandfathered" all instances of delivery failure prior to a company appearing on the list. Grandfathering exempts those trades from any delivery requirements. Critics of that part of the rule, which never was submitted for public comment (a requirement for SEC rules), contend that it effectively pardons improper and potentially unlawful delivery failure, by suspending any requirement to deliver FTDs prior to appearance on the list, in perpituity.

Reg SHO also exempted certain participants from delivery for certain types of transactions, namely options market makers hedging their put option sales, and market makers engaging in "bona-fide market making." Critics of these exemptions argue that bona-fide market making doesn't involved long-term delivery failure, nor should speculators in the options market be allowed to enjoy no-cost hedging for their business activity at the direct expense of stock market investors.

The SEC introduced several proposed changes designed to rectify these deficiencies, which were submitted for public comment comment in August, 2006, with the comment period closing September, 2006. In March, 2007, it re-opened the comment period for yet another 30 days, further delaying any changes or improvements to the rule. Critics of the rule point out that the level of delivery failures has actually increased since it was enacted, that some companies have been on the threshold list for years, and that the 1934 Securities Exchange Act requires prompt delivery and settlement, thus any rule allowing extended delivery failure violates that Act's mandate.

State regulators have taken a more severe stance against delivery failure as a threat to the integrity of the market system, however the SEC is the ultimate regulator for the national market system, so state action, as well as state legislative action, has had limited impact to date.

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