Mechanics of Naked Shorting
Mechanics of Naked Shorting
``He who sells what isn't his'n, must buy it back or go to prison.'' –Daniel Drew
The following is from Senator Bob Bennett. This speech was made a year ago when Bennet said, "I understand we can't set a time for [a hearing] right now; there are too many other things going on in the Banking Committee." I wonder how busy they are this year because of fraud. More busy or less busy?
bennett.senate.gov
How to Ping-Pong Shares
But I have discovered something that appears to be a way around the SEC rules. Here is the transaction: Broker A shorts 1,000 shares. At the end of 13 days, which is the period he has to produce the shares, he has been unable to find any--probably hasn't even looked--but he has this requirement under the SEC rule to produce 1,000 shares. So he goes to broker B and says quietly, “Sell me a thousand shares.” Broker B says, “I don't have any.” Broker A says, “It doesn't matter; sell me a thousand shares so I can cover.” Broker B, “All right. I will sell you a thousand shares so you can cover and there will be no passage of money; this is a deal between the two of us--a rollover.” At the end of 13 days, broker B has to deliver a thousand shares, so broker A sells the same 1,000 phantom shares back to broker B, and they ping-pong these back and forth for as long as they want.
The one thing that convinced me this was real was when the investment bankers sat me down in front of a screen and showed me the stock trading of a company that has been out of business for 3 years, and the stock trades regularly, every 13 days. You know exactly what they are doing.
The brokers are rolling the stock back and forth every 13 days, so they are meeting the SEC requirements--they are delivering--but the shares they are delivering to each other back and forth do not exist. The company was driven out of business by the short sellers who made it impossible for them to go to the capital markets.
So you can have a situation where people are selling shares that don't exist, taking commissions on the sale, and the profits of the sale, and never, ever having to produce the shares.
Possible Solutions (Bennett)
First, I think there should be a rule which says there cannot be borrowing, that brokers cannot borrow for short sales more stock than is on deposit with the DTCC. I think that is obvious. If there are 3 million shares of XYZ Company on deposit at the DTCC, people should not be able to short sell 4 million shares.
So my first recommendation would be that the DTCC cannot make available as loans for short sellers more stock than they have on deposit. Once they have reached the point that 100 percent of the shares they have on deposit have been loaned out, they can't loan out any more. I think that is an obvious commonsense recommendation, but it doesn't apply now.
Secondly, I think there ought to be a rule which says a broker cannot be paid a commission on a short sale until the shares are delivered. Back to the business model. The broker sells $5,000 worth of stock. He can do it every day. He can get $5,000 every day, without ever having to cover the stock, and he gets a commission on making the sale. So if you say, no, there will be no commissions paid until the stock is delivered, you will have a significant impact on stopping this activity.
We Owe It To Them
As I said in my opening remarks, this is a tiny matter. It does not involve very many people, but to the people who are involved, it, frankly, can be a matter of life and death. There are enough of them starting businesses and creating entrepreneurial activity in the United States that we owe it to them to find out exactly what is going on with respect to this activity.
[The premise of this being a tiny matter will soon be explored in another article.]
Sources:
Senator Bennett Discusses Naked Short Selling on the Senate Floor
July 20, 2007
bennett.senate.gov
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