re: Abusive Shorting -- A Thoughtful Respond to the SEC's New Rule
In a bold move yesterday on Capital Hill Chris Cox, Chairman of the Securities and Exchange Commission announced before a Senate sub-Committee that the SEC would be instituting an executive order regarding the short sale execution in the markets of our banking institutions.
Chairman Cox announced that the executive order would require that all short sales in a select and limited list of equities would require a pre-borrow to be exercised prior to trade execution. Under normal circumstances a locate of a share to borrow is all that is required when initiating an effort to engage in a short sale. The need to borrow the stock only commences once the short sale was executed.
In other circumstances the Commission has granted market makers additional exemptions allowing the execution of “naked short sales” to be exercised where neither a locate nor a borrow transpire. Under these limited exceptions the trade enters into what will become a fail to deliver status to the equity purchaser until such time as that market maker buys in the naked short.
While this may sound complicated and cumbersome it must be recognized that under Securities Law all trades must be executed with the intent of three-day settlement. When such trades fail to settle within this timeframe it is implied that the broker-dealers who engaged in this contract to trade will take all appropriate steps to settle out the trade including the action of buying in that client.
Outside of the exemptions to market participants creating liquidity no other trading entity is granted the right to sell what can not settle.
Jakab Spencer of the Wall Street Journal responded back to concerns I had with the tone of his article addressing this issue. According to his sources who he identifies as market professional “One reason for rising failures [naked shorts] is that activity by both long/short hedge funds and by institutional and even mutual 130/30 funds has increased substantially in recent years and has led to increased net short interest.”
Nope sorry, none of these trading entities qualify for exemption for trade settlement regardless of level of trading activity they choose to engage in.
But ironically these are the very institutions the Chairman has chosen to protect from further abuses. Institutions have become the facilitators to naked short selling and yet financial institutions are the only public companies protected under this executive order.
When asked why the list was so restrictive an SEC official said the agency focused on financial firms that were of a significant size. "Drastic falls [in stock prices] can end up destroying confidence in the firm altogether, which is not true for bricks-and-mortar industrial companies," the official said.
Apparently this SEC Official has lost touch with how the investing public invests their capital.
Take any thinly capitalized company looking to grow under the protective umbrella of the US Capital Markets. Each relies heavily on share value to raise capital to re-invest in development. Share value requires long term investor interest in the company’s future.
Now add the drastic and uncontrollable fall in stock pricing due to abusive short selling.
What results is a loss of confidence in company growth by the limited investment base this thinly capitalized company can attract. This loss in confidence further impacts stock pricing and makes it far more difficult to raise necessary capital to succeed. It only takes a short window of time before a growing company stall under the pressures of a death spiral. Those investors lost will forever be lost from future re-investing because that is how an investor thinks.
Once burned never return to the fire.
The abuse to these thinly traded companies takes place through a network of abusers but in the end the network can only be facilitated with the aid of the very institutions Chairman Cox just threw the lifeline to.
When the trade fails settlement it is the Goldman Sachs, the Lehman’s, the Merrill Lynch’s, the Morgan Stanley’s, and all the other prime brokerage houses who hold these fails on their books indefinitely. Each colludes with each other to dismiss the settlement responsibilities associated with the contract to settle they agreed upon. The 3-day settlement periods are ignored for trade commissions, liquidity, and the rights to future business from those who sold what did not exist.
If any company in the US Capital Market deserves an umbrella of protection it is a company publicly recognized as over-burdened with settlement failures. These companies are not hard to find, the list is published daily by the major market centers, it is called the Regulation SHO threshold security list and there are 591 public companies identified today.
Taking a closer look at the SEC’s special list of protected entities none are SHO threshold securities. By choosing non-SHO companies put protecting such against naked short sales falling below 0.5% the SEC is making admissions that in highly capitalized companies it does not take 0.5% of the shares outstanding to fail to achieve manipulation levels. What exactly does that say about the threshold levels defined?
The real solution lies with a division of the SEC that has yet to accept that this abuse exists.
The SEC’s Division of Trading and Markets that is responsible for drafting rule changes that address the evolution of trading patterns in the industry to insure as trading patterns shift abuses are not the resultant outcome. When it comes to short selling a Committee led by James Brigagliano has been working [ignoring] the underlying issues of short sale abuses. Brigagliano has failed to conceptualize that liquidity generated from shares that do not exist is not healthy liquidity regardless of market capitalization so what we have are fractured rules and gaping loopholes.
The solution for Chairman Cox is simple.
First, the SEC must expand this executive order to include all issuers listed under Regulation SHO until such time as the Division of Trading and Markets can get their act together and propose to the Commission staff permanent rule changes.
Second, the proposed rule changes should strictly prohibit the options market maker from engaging in a naked short into the equity market to hedge their book. If the market maker chooses to allow the book to get vastly out of balance due to their pricing strategies the only option available to them on a hedge would be to short the equity similar to any other public investor. There can no longer be the unlimited volume of Put contracts issued against a public company where the resultant is unlimited naked shorts exercised into the equity market at the expense of long equity investors.
Third, the SEC must reconstruct the uptick rule to a level that is functional to today’s pricing increments. The elimination of the rule has shown that the opportunity to overwhelm pricing stability with short sale domination can and will create a market panic that destabilizes the markets.
Finally, the SEC must place firm constraints on how long a failed trade exists regardless of level of fails in a market. There are few valid reasons for a failed trade to persist for any length of time, including bona fide market making, and thus limits must be placed on what is considered a reasonable effort before additional more drastic steps will be required. The SEC can no longer allow the institutions that facilitate these fails to ignore them because it is not cost beneficial to have them closed. That is not an option affordable to the marketplace.
Naked Shorting finally made it to the front pages but it took the destruction of the #5 US banking institution, the near destruction of the #4, and several more sitting on this fence to get Washington to take this seriously. Unfortunately, while these may represent huge market capitalization losses it pales relative to the total capitalization losses incurred over the hundreds of smaller companies abused and those smaller investors. It also pales in comparison to the jobs and technologies lost to this abuse.
Full Story: investorvillage.com
Cheers, |
