Patrick hits another one out of the park. Thanks Basserdan for dropping it by the NSS thread.
A Message of Peace to Wall Street
August 3rd, 2008 by Patrick Byrne
Greetings, and peace. As we Irish say, “I’m sorry for your troubles.”
In today’s Salt Lake Tribune there is a story that is 100% correct: an elder statesman of the hedge fund industry sat me down two years ago to tell me that I had become the most hated man in living memory in New York, that you folks despise me utterly, and so on. All true, I’m sure. So it goes.
However, from examining the logs I also know that thousands of people from major Wall Street institutions have visited this site and are passing these pieces around. I was planning on writing an open message to you in the 2007 holiday season, or the 2008, but while I have but little influence over this course of events, I have even less over their pace. Now it is August, but the time to write this come.
I have said harsh things about Wall Street. Harsh words have been said about me as well. Let’s get past that for a moment. Instead, I have a story to share before we will return to our battle.
Richard Feynman, one of the greatest physicists of the 20th century, sat in a drum circle telling stories that were compiled into the book Surely You’re Joking, My. Feynman (which can be purchased conveniently at a discount site I know). Some stories came from his days as a 24 year-old quant working on the Manhattan Project. One concerns the time he was sent to review plans for the factory in Oak Ridge, Tennessee, where the uranium for the atomic bomb would be purified. I will quote from it at length, both for its charm and, also, because it says something about the battle into which you folks and I seem to be locked.
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Rather than c&p Bryne's "Feynman story" to this lengthy essay, I'll leave it to be 'clicked' upon (link below) by anyone who may be interested in reading it.
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Feynman was a funny guy, and I encourage you to read his book. I include it here for the resemblance it bears to our battle over “naked short selling”. I am not claiming to be smarter or more moral than any of you folks. I just believe that you have a problem in your “factory” (the nation’s stock settlement system) of which you are unaware. That problem is the systemic risk created by unsettled trades. Like the U-235 in Feynman’s story, this can be dangerous, and from my point of view, it looks like you folks have not paid much attention to the safety question at all. We of the Market Reform Movement are worry about “how much material can come together before there’s an explosion.”
I will assume that all Wall Street readers understand why an unsettled trade is a derivative, and specifically, a Contract For Difference (“CFD”). You know also that the value of a derivative is a function of some underlying event (that’s what makes it “a derivative”.) Unsettled equity trades seem unusual to me in their ability to affect directly and immediately the underlying events of which their values are derivative. Florida orange farmers wanting to hedge their risk can buy all the derivative contracts on sunshine in Florida that they want, but it will not affect the amount of sunshine in Florida. Similarly, Credit Default Swaps do not affect the rates of third party defaults (in any immediate sense, anyway). But from the SEC’s recent Emergency Order it would appear that they, 19 financial institutions now enjoying special protection, and 8,5000 banks who want the same protection, have come to recognize naked short selling can affect share prices.
This is not to say that naked short selling always affects the underlying event (one could naked short Berkshire Hathaway all day long and it would not affect its share price), nor is it to say that unsettled equity trades are the only derivatives with this capacity (various debt-related derivatives may be another). However, if one considers naked shorting in small and mid-size stocks, one sees that it is a derivative that affects the underlying events immediately and directly.
So if the underlying event drives the value of this derivative (again, that’s what makes it “derivative”), and the derivative can drive the underlying event, we have a strongly self-reinforcing dynamic. That’s a “short squeeze”, and it is what makes unsettled trades particularly dangerous. A market participant may believe she has simply written CFD’s on (by failing to deliver) 10 million shares of some small software maker that is currently trading at 20 cents. She carries that as a $2 million liability. But she cannot settle this CFD with cash. To close her position she must buy stock, and if the stock in question trades 50,000 shares/day, it is going to take her a long time to buy those 10 million shares, and as the price squeezes it will cost her a lot more than $2 million to buy them.
Thus, when it comes to the potential liabilities associated with unsettled equity trades, the nominal liability is a fraction, and perhaps a quite tiny fraction, of the money it is going to take to clean up that liability. In the Feynman story, “…they did not know that the neutrons were enormously more effective when they are slowed down in water. In water it takes less than a tenth — no, a hundredth — as much material to make a reaction that makes radioactivity. It kills people around and so on. It was very dangerous, and they had not paid any attention to the safety at all.” Similarly, unsettled equity trades in our capital market could well be “enormously more effective” than their current nominal value would indicate.
How many times more effective? 2? 10? 20? I have no idea. However, for ease of reference, I will refer to this as “The Feynman Principle”, and the ratio of true-cost-to-cover versus nominal liability as “F”.
Let us look at where these unsettled trades can reside within the piping of the “factory” that is our nation’s stock settlement system, The Depository Trust & Clearing Company (“DTCC”). I will use Goldman and Morgan as hypothetical examples only.
• “Desked trades” – Imagine Goldman takes your order for 1,000 shares of stock, but stashes your order in a desk and sends you statements saying that you have those 1,000 shares in your account (and use your money towards the $10 billion they pay themselves at the end of the year for being so clever). They have written a CDF to you without your knowledge: there is a 1,000 share failure-to-deliver to you at Goldman (which no one else knows about, incidentally).
• Goldman has one client sell 5,000 shares and another buys 3,000. The seller never delivers. Goldman “pre-nets” the trades before submitting them to the DTCC. Hence, the DTCC sees only 2,000 shares of the failure.
• “CNS netting” - Goldman submits to the DTCC’s Continuous Net Settlement system that it sold 2,000 shares that it does not deliver. Imagine Morgan Stanley was on the other side of that particular trade. But maybe Morgan has a client who sold 1,000 to a Goldman client, and which that Morgan client failed-to-deliver. The DTCC nets the two trades, and therefore sees just 1,000 shares of failure (Goldman to Morgan).
• “Stock Borrow Program” (“SBP”) - The DTCC looks at that 1,000 share failure, and says, “We have 400 shares we can loan Goldman from our Stock Borrow Program”, i.e., from the accounts of other BD’s within the DTCC. That reduces the failures it sees to 600.
• “Ex-clearing” - Suppose Goldman and Morgan apply to the DTCC to move 500 of those fails ex-clearing, and the DTCC approves. Those 500 FTD’s are turned into a derivative contract between Goldman and Morgan. As a private contract, it is not regulated by the SEC, and the DTCC does not even know when that contract gets cleaned up, if ever.
• Offshore – Suppose someone sells 1,000 shares into this market from a foreign offshore exchange? There is a different terminology to describe such failures, and therefore the data is hard to get to. What is clear, however, is that there is little pressure to clean up failures among exchanges.
In this example, there are 100 failures at the CNS level. Yet there were 7,000 failures throughout the system. Therefore, we should remember that, however many unsettled equity trades there are at the CNS level, it is likely to be a fraction, and maybe a quite tiny fraction, of the total unsettled trades in the system.
What is the ratio of total fails in the system to those trapped in the CNS system? No one seems to know (and in fact, while the individual pieces of data are known individually, I strongly suspect that no one party has the bird’s eye view of how many of these there are at all levels). The estimates I am told range from 3 to 15. For ease I will refer to this as, “The Iceberg Principle” and the ratio of total failures to CNS failures as “F”.
So how big a problem is this?
•The last reported size of the failures-to-deliver at the CNS level are $8.7 billion.
•By Iceberg Principle, total failures ˜ I X $8.7b = $30 – $120 billion.
•By Feynman Principle, total cost to clear = F X I X $8.7b = F X ($30 to $120b).
So respectfully, Wall Street, I believe you are Oak Ridge, Tennessee, blithely going about your jobs at the factory, taking for granted “the piping” that is our settlement system. I believe you have manufactured, and are sitting squarely on top of, a financial atomic bomb. That’s not good for you, of course, and if it goes critical, America is downwind.
Since I have learned that these columns are getting passed around Wall Street, I thought it would be a good idea to explain to you why I took on this Crusade (or “Mitzvah” or “Jihad”, depending on where you stand). I truly wish that this could be solved without anyone getting hurt, and in fact, that is what I am trying to see happens. I’m not vindictive, and I do not despise anyone in return. I believe that many of you know that this is a right and necessary thing to do. (Of course, feel free to lend a hand if you get a chance!) And in any case, I am sorry for your troubles.
Peace.
Sincerely and respectfully,
Patrick M. Byrne
deepcapture.com |
