Caught On Tape: A Naked Swindle
Continuing with the theme of naked short-selling, I have a video that was given to me last week that will allow people to see how naked short-selling can take place.
This video is only 31 seconds long (scroll on down to view it), and what it shows is a day-trader trying to sell short shares in a major NYSE-traded stock. To disguise the identity of the trader, I’ve had to edit out the name of the company in question — I’ll call it BANK X for short. What I can say is that the stock in question is one of America’s largest financial companies and the recipient of an enormous amount of public bailout money, so the fact that its stock can be manipulated is something that should be a concern to everyone.
In the video, which believe me doesn’t look all that sexy, the trader is using an online trading platform. His clearing firm is a company called Penson Financial Services, which, though not particularly well known, has in recent years suddenly become (by volume anyway) one of the biggest such firms in the country.
A quick aside, before I get to the specifics of this video. My recent Rolling Stone article doesn’t talk much about day-trading, which in retrospect is probably too bad. Day-trading is an increasingly large percentage of all trading on Wall Street, and day-traders have a unique ability to impact the value of stocks via naked short-selling. One the big reasons for this is a loophole in the existing rules governing naked short-selling, called Regulation SHO or Reg SHO.
As it stands, when a day-trader puts an order in to his broker to make a short sale in this or that stock, the broker does not have to actually locate those shares right away. Instead, all he has to do is have “reasonable grounds” to believe that he can locate those shares. Here is how the rule reads, even now, even after the so-called “tightening” of the Reg SHO rules last fall:
Reg SHO “requires broker/dealers, prior to effecting a short sale, to borrow or arrange to borrow the securities, or have reasonable grounds to believe that the securities can be borrowed so that they can be delivered on the date delivery is due.”
Now, this is already a very funny piece of regulatory policy — asking greedy-ass financial companies to determine what to them is a “reasonable” effort to follow the rules. But it gets funnier when you throw the peculiarities of intra-day-trading into the mix.
Say you’re one of those big brokers, and you’ve got a day-trader who wants to make a short sale. You know he is going to close out his position by the end of the day. You know, in other words, that as far as he’s concerned, you’re going to be net flat by the time the business day ends.
Under that standard, a “reasonably” greedy broker might just determine that any amount of any security can be approved for this trader to sell, regardless of whether he, i.e. the broker, can locate it or not.
Why? Because his trader is going to close out his position by the end of the day anyway. So why bother properly locating the stock? It’s not like you’re going to have to run around three days later to find the stock to deliver for legal settlement. Your customer isn’t even holding his position overnight.
This is why Reg SHO doesn’t really work. If there was a hard pre-borrow requirement that actually forced traders to physically locate and borrow shares before they sold them, you wouldn’t have this problem. But what they have instead is a system that leaves three days of wiggle room. As it stands, shares must be delivered within three days after the sale, or else the clearing firm must buy shares to close out the failed trade.
But for a day trader, none of this matters. You’re buying and selling within the space of one day. Who gives a damn about three days?
These big clearing firms know this. They also know that competitive advantage in getting the business of these intra-day traders depends on providing locates and providing them fast. A clearing firm that worries about the rules and whines about not being able to locate this or that stock is not going to keep the business of a lot of these day traders. So you see a lot of cut corners.
This video is an example of a cut corner. A second-by-second explanation:
:00 If you look at the display in the first seconds, you will see that the customer is trying to sell 100 shares of BANK X short. You can tell it’s a short sale by the purple box near the top marked “Short.” To the left of that, you’ll see that “order quantity” is 100.
:01 Now if you look at the bottom of the display, you can see that the trade has been rejected, because BANK X that day is on the hard-to-borrow list. It reads REJ – HARD TO BORROW: SHRT 100. Without getting too technical, you don’t need a formal locate when a stock is on something called the “easy to borrow” list. But BANK X shares that day were not easy to find (without digressing too much into other complicated realms, there was something going on with BANK X that day that was inspiring lots of people to snatch up its shares). So the trade was rejected temporarily, and the trader was then forced to ask for a formal locate of BANK X stock.
:07 A prompt comes onscreen. Through this box, the customer is going to ask Penson to locate shares in BANK X. But how many shares? This is where it gets interesting.
:11 At eleven seconds, you can see the customer start to fill in the box in the middle of the prompt where it reads, “Locate quantity.” To disguise the identity of the trader, I’ve blocked out the first number in the sequence. But you can see that the number is in the tens of billions of shares. Now, the float for BANK X that day was only five and a half billion, meaning there were only five and a half billion BANK X shares in circulation. Without disclosing the actual number, I can tell you that the customer asked for a locate of shares in an amount that was at least five times the number of BANK X shares actually in circulation. Such a locate, in other words, could not possibly be filled.
:17 At seventeen seconds, at the bottom, you see that the firm Penson has now approved the trade and” located” the multibillion amount of shares. The trade goes through.
This doesn’t sound all that dramatic and as video sequences go, it sure as hell isn’t the Paris Hilton sex tape. But this is an example of how naked short-selling can happen. If you don’t need to actually find the stock before you sell it, there’s no real brake on speculative naked short-selling. If a clearing firm will give you a locate no matter how big your request is, there is no real barrier out there to stop this kind of activity.
Why does this matter? Let’s say there’s a big company that is coming under attack by short-sellers — let’s take Bear Stearns for example. Let’s say it’s March 11, 2008, and Bear stock is trading at $62, but dropping. Once the run begins and the stock price begins to fall, you might see day traders piling on. If they don’t need to actually locate Bear stock, they can simply sit there and batter the hell out of it all day long by continually selling short without locating the shares first.
The best explanation I’ve seen of this problem comes from John Tabacco, the founder and CEO of Locatestock. Full disclosure: Tabacco’s company offers services designed to avert the problems of naked short-selling by using a new technology (invented by Tabacco) that provides real and legal locates to traders. So he has a financial interest in outlining these problems. He’s also a garrulous right winger who has a Sean Hannity-style TV show and probably doesn’t agree with me about anything outside finance. But he’s a great guy and has taken a lot of time to talk to me about Wall Street in recent months.
Tabacco gave a speech about this issue back in April in which he talked about the effect of day traders repeatedly hitting a stock without locating the shares first. He speculates that some of this played a role in the Bear and Lehman episodes, among others.
“The more artificial intra-day selling pressure is impacted on a single stock, the more the pool of real shares is diluted,” he said. This, in turn, creates a “cyclical spiral” in which the issuer’s “real shares are detrimentally harmed, and in some instances that we’ve seen lately, beyond repair.”
Again, a lot of this stuff is complicated and not only hard for people outside the finance world to follow, but kind of, well, boring as well. But it’s through these tiny regulatory loopholes, these little nooks and crannies, that the economy gets manipulated. The effect of all of these regulatory gaps has been to transform Wall Street from a means of connecting capital to good business ideas into a giant casino, where the object of the game is shaving little slices off the great flows of money as you push them back and forth using a great big toolbox of manipulative techniques. This is one of the tools.