November 22, 2005
Irving Faught, Administrator
Department of Securities
First National Center, Suite 860
120 N. Robinson
Oklahoma City, OK 73102
Re: Comments to the “NASAA Listens” Forum, November 30th 2005
Dear Mr. Faught:
Please consider the following general comments on the issue of limiting the use of targeted, strategic and persistent settlement failures in U.S. Equities Markets. If we are to curb abusive naked short-selling, then we must both structurally and culturally transform the underlying system through which settlement failures occur and are allowed to persist.
State regulators are in the unique position to address the fails issue from the front lines, as strategic and persistent fails directly affect companies and individuals of each and every state (and the economies therein). State regulators should not only pursue those who utilize naked shorting as a strategy, but their joint efforts can help pressure the SEC the DTCC to modify its own attitudes towards pro-activity and transparency in the fails issue.
I. We must affect the seller’s costs of failing to deliver securities.
It must be understood that participants who strategically fail to deliver securities are rational. Currently, strategically failing to deliver is a less costly activity, than that of legally borrowing and short selling a stock. Failing to deliver shares is equivalent to borrowing shares at a zero rebate rate. In the current market culture, fails to deliver will continue to persist, until and unless the costs associated with delivery failures are increased to the point that it becomes economically irrational to fail delivery; The monetary, exclusionary and other punitive consequences of delivery failures must be increased substantially.
Accounting for a failed delivery based upon its current, marked-to-market value does not adequately represent the associated risks of open fails positions. Consideration should be given to the use of risk-based methods of marking failed deliveries. This would have the effect of increasing the book value of open fails, and would serve as effective deterrent to those who would consider placing strategic fails, or allowing them to persist.
II. We must effectuate change in the current culture of the markets.
No other action more clearly demonstrates the culture of fails than the SEC’s grandfathering of pre-SHO fails (This topic will undoubtedly receive its due attention at the public forum.). But there are numerous other examples. Many of the existing rules and procedures, which govern the receipt and delivery of securities, stand upon the “good faith” of “honest brokers”. Yet it is these same “good faith” exceptions that can be used to perpetuate the delivery failures. It is time to seriously consider amending the relative rules by shifting their foundation, away from reliance upon the trustworthiness of market participants, and towards the fundamental protection of investors (and companies). Aside from the manipulative strategies of the failing sellers, there is an apparent unwillingness by the NSCC/DTCC to assume any accountability for the ~$6 billion in daily marked fails. The SEC seems reluctant to globally enforce the laws preventing such fraudulent trading. And the buy-side brokers do not appear to be upholding their legal and fiduciary responsibilities to properly receive and segregate their clients’ securities. No one gives the buyer of a failed trade her money back; she is neither informed of the fail, nor made aware of the underlying reason for the fail. As such, the buyer of a failed trade is being systematically denied the right of being an informed investor.
15c3-3 (n) of the ’34 Securities Exchange Act, introduces the concept that a broker - dealer, deemed to be acting in “good faith”, can receive an extension in time to receive securities. NSCC Rule 21 appears to provide indefinite “credits for delivery”, to “any member who activates the DTC’s ‘Honest Broker’ procedures”, “for each open CNS short position”. NSCC Procedure VII gives member “the ability to elect to deliver all or part of any short position”, through the use of exemptions. These are but a small sampling of the rules and procedures that help foster the culture of fails. We should seriously consider the ‘as-written’ usefulness of such rules and procedures, against the nature, size, and persistence of the current level of marketplace fails.
In order to completely dissect the market issues that contribute to the culture of fails, we must also consider the level of accountability to be attributed to the NSCC/DTCC, as it relates to the creation, management, and persistence of open positions within the CNS system. The legal definition of assume is ‘to take over (the debts or obligations of another) as one’s own’. Consider these excerpts from NSCC Rule 11-2(b)(c): “...each obligation of any Delivering Member to deliver securities to any Receiving Member under any [CNS] transaction, shall be assumed by the [NSCC] at the point...when the [NSCC's] guarantee to complete the transaction becomes effective...the [NSCC] shall be deemed to have guaranteed completion of a CNS Transaction when the clearance and settlement process for the transaction has reached the stage at which the [NSCC] will complete the CNS Accounting Operation for such transaction...Simultaneously with the assumption of any such obligations by the [NSCC], the related rights of the Receiving Member to receive securities from the Delivering Member and the related rights of the Delivering Member to receive payment from the Receiving Member for securities delivered shall be assigned to the Corporation.”
Also consider the following excerpts from NSCC Rule 19. “In connection with any sale of securities by the Corporation...the [NSCC] may pledge, hypothecate, transfer, create a security interest in, or assign any or all of such securities for the purpose of securing loans to, or other financing for, the [NSCC] ... (including, without limitation, loans or other financing obtained for the purpose of facilitating the disposition of securities and/or financing any settlement obligation of the [NSCC])... Consequently, this Rule shall not be construed to limit the Corporation's right to pledge, hypothecate, transfer, create a security interest in, or assign any securities or instruments in any other situation, whether or not there is a provision of the Rules or Procedures specifically authorizing any such action.”
It is a non-starter to address the fails issue, in the above context, by focusing on the procedures of Stock Borrow Program. The are many more relevant issues to address, as they relate to the NSCC’s assumption of the obligation to deliver/receive securities, their guarantee to complete transactions, and their right to “pledge, hypothecate, transfer, create a security interest in, or assign” securities for “financing any settlement obligation of the [NSCC]”, including the DTCC’s Rule 21 allowance for credits to participants against open short positions, and other similar rules and procedures.
In March of 2005 the DTCC rebutted a Euromoney article on naked shorting, in part, as follows: “Other examples of errors in the article included mentions of a “lending pool” that doesn’t exist, no mention of the fact that neither DTCC nor its subsidiaries have the power to force buy-ins by member firms, and the fact that DTCC is not required under Reg SHO or any other U.S. regulation to release confidential customer information on the number of fails to issuers, only to regulators and markets.”
It is so obvious that a “lending pool” exists, that it should instill fear across the globe to learn that DTCC is either unaware, or unwilling to acknowledge, that each security has a finite number of shares issued and outstanding, that within the total set of outstanding shares are a finite number of shares held in non-marginable accounts, such as cash or pension accounts, or are otherwise restricted from being pledged, thus leaving a finite number of shares that are eligible to be leant and borrowed (aka the “lending pool”, or the “borrowing pool”). Further, in response to the SEC Proposed SHO requirement that the NSCC determine which stocks meet the threshold level of fails, the response was that the NSCC could not perform this calculation, because they do not keep record of the issued and outstanding shares of the securities (the trades of which, they themselves, guarantee the completion of, and have the right to create securities interests in). These realities, in juxtaposition to the nature of fails as they exist today, and in relation to current events and other recent authoritative research on the issue, clearly expose the lack of a proper audit trail between participants, the NSCC, and the DTCC, as it relates to justifying the sum of outstanding short interest plus open fails, credits, exemptions, et al, against the number of total shares eligible to be borrowed of any given security.
It is also worth noting, within the CNS system, when fails occur, that the DTCC effectively “settles” the fails in at least two different ways. (1) By creating an entirely new transaction, whereby the DTCC becomes the short seller and borrows a share from a willing participant, to deliver to the buyer in the failed transaction; thus moving the failing-seller’s obligation outside of the CNSS, and marking the account of the lender’s client with an IOU for a share which the failing-seller has yet to purchase and/or deliver. (2) In the instances where there are no willing lender-participants, it remains unclear where the shares originate from, that ultimately end up in the account of the buyer of the failed transaction. But we do know for certain in these cases, that the buyer always forfeits his money, and receives shares on his brokerage statement. If there are no willing lenders, than one must assume that it is the buyer who (now) receives the IOU for a securities interest, and that the DTCC, in these cases, has become both short-seller, and lender, in the new “settling transaction”. This creates a clear conflict of interest in all transactions through the CNS system, as the NSCC/DTCC is not only the clearing firm, but in some cases becomes both the short-seller, and the lender, as well. In today’s environment, we must re-address the rules which may perpetuate such conflicts, and seek the same level of auditing and transparency of securities positions, as we require of the companies whose shares are processed through the system. Last, proper auditing mandates made upon the DTCC and its participants would force the exposure of any ex-clearing (non-CNS) fails, or desking activities; These ex-clearing and desked fails (e.g. markers/obligations created by participants), while not directly evident within the CNSS data, must be quantified before for the DTCC can ascertain the real number of economically un-encumbered shares available for any given security.
III. We must affect the system through which delivery failures are allowed to persist.
What has evolved in the U.S. markets is a system of fungible trading, in an indirect holding environment, where the associated costs, rules, and culture allow overly-complex derivative transactions, and un-checked manipulative trading (such as strategic delivery failures), with no meaningful enforcement or mechanism to discourage the practice of over-borrowing and under delivering.
Our system of trading has in a very real sense altered the meaning of what a “share” is, and what it represents. The securities interests have been torn apart and the underlying rights (to vote, sell, receive dividends and distributions, etc.) have been recklessly un-attached from each other. A single share can now be legally encumbered in one direction, and economically encumbered another, creating artificial shares, with no mechanism to differentiate between rights born by the company, and the contractual rights (IOU’s) created by the system. This is clearly in contrast with the ’33 act’s restriction against the sale of unregistered shares. And it exemplifies the systemic risk that is ever-growing in today’s markets.
Normal short selling creates artificial shares in the market. Likewise, IOU’s for securities interests, placed against settlement failures also create artificial shares (which are effectively counterfeit, in cases where total “IOU’s” exceed the number of unencumbered shares for a given security). Because of the fungible nature of shares within the system, it is functionally impossible to discern between the artificial shares and real shares in the market, creating real systemic risk. We can however, rather easily, if those entrusted with the responsibility to protect investors and promote efficient markets, choose to do so, identify those who are responsible for the fails, as well as those responsible for the creation of excessive credits for delivery.
Following is a paragraph from the SEC’s Final Rule SHO: “Some commenters argued that under the confines of current settlement practices and procedures, it is not practical to assign delivery failures to a particular clearing firm customer account. It was noted that because NSCC’s continuous net settlement (‘‘CNS’’) system nets all buys and sells in each security for each NSCC participant, broker-dealers cannot determine which customer’s transaction or account gave rise to a failure to deliver.[92] We note that while this may be the current situation in the industry, if the Commission believes that the rules as adopted are not having the intended effects of reducing potentially manipulative behavior, we may consider additional rulemaking that could require broker-dealers to identify individual accounts that are causing fails to deliver.” In light of the current fails data, almost a full year into the implementation of SHO, it is time for the SEC to not only “identify individual accounts that are causing fails to deliver”, but for the SEC and all agencies responsible for protecting markets, companies, and individual investors, to address the underlying systemic flaws (and the culture) that allow the strategic use of persistent fails, as an affront to our national economy, and to the companies and individual investors who faithfully participate.
Sincerely,
Dusty Smith
investigatethesec.com |
