Short selling

Is a bet that a stock price will decline. A legitimate short seller borrows stock and then sells it, hoping to buy back the same amount of stock later, at a lower price, for return to the lender. Legitimate short selling is legal and an important tool for liquidity and efficient price discovery.

Naked short selling

Involves selling stock without borrowing (or sometimes even locating) the stock. If a naked short seller does not borrow the stock he sold, he will be unable to deliver that stock and settle the trade. This creates what is called a "failure to deliver" (FTD). Naked short selling is generally illegal.

The exchanges do not disclose whether short positions are naked. To complicate matters, physical shares of stock have been separated from electronic claims of ownership through “dematerialization.” Modern stock markets trade in “share entitlements”, not real shares. Retail brokerage customers’ account statements do not distinguish between real shares and share entitlements. Thus, purchasers of securities have no way of knowing whether shares they bought were actually delivered to their broker.

FTDs create phantom shares that circulate in the system as real shares. Just as counterfeit currency dilutes and destroys value, phantom shares deflate share prices by flooding the market with false supply. FTDs threaten market integrity in at least three ways:

• The corporate voting system is undermined. FTDs lead to more claims of ownership than there are shares issued, and attempted over-voting at the broker-dealer level is routine;
• Companies and shareholder value are destroyed;
• Market integrity is threatened. The true cost of cleaning up FTDs through buy-ins far exceeds the mark-to-market value of those failed positions. This poses systemic risk to financial markets.

Regulation SHO was implemented by the SEC in January of 2005, in order to curb abusive naked short selling and reduce FTDs. Regulation SHO requires the exchanges (e.g., NYSE and NASDAQ) to publish daily the Regulation SHO Threshold List, which lists firms with FTDs above a calculated threshold. Since Regulation SHO was enacted, nearly 8,000 unique tickers have appeared on the Threshold List.

Regulation SHO only reports victim companies; the institutions who fail to deliver are not revealed. The size of past (but not current) FTDs can be obtained quarterly on the SEC's website. Neither the SEC nor the exchanges will disclose the institutions who fail to deliver as “fails statistics of individual firms…is proprietary information and may reflect firms' trading strategies.”

The SEC’s prediction that firms could not remain on the Threshold List longer than 13 days was false:

New data reveal significant FTDs as a fraction of select issues and across all U.S. exchanges:

Large U.S. brokerages collectively own the Depository Trust and Clearing Corporation (DTCC), which operates with little SEC oversight and denies the existence of a systemic problem. The DTCC claims that failed trades at the end of 2007 summed to $7.5 billion—1.5% of the daily dollar volume. But that $7.5 billion is only the “mark-to-market” value of failed trades; the true cost is far higher:

The true magnitude of FTDs is obscured by Continuous Net Settlement (CNS), which nets failures against shares held at DTCC.18 The DTCC’s Stock Borrow Program (SBP) further obscures the truth. Furthermore, the statistics above omit "ex-clearing" —that is, trades cleared directly by brokers bypassing the DTCC. Ex-clearing trades are exempt from the reporting requirements of Regulation SHO.” FTDs in ex-clearing are likely many times larger than the quantities discussed above.

NAKED SHORT SELLING: THE SOLUTION

On October 17, 2008, the SEC announced three new rules governing naked-short selling:

• Naked-short selling anti-fraud rule 10b-21, which forbids "any person to submit an order to sell an equity security if such person deceives a broker or dealer, a participant of a registered clearing agency, or a purchaser about its intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before the settlement date."
• Rule 204T (an interim final rule), which requires “hard” delivery of shares three business days after a trade (T+3) and mandatory close-out of unsettled trades. Penalties for violation include prohibition of further short sales and a mandatory pre-borrow requirement.
• Elimination of Regulation SHO’s options market maker exception.

These rules are welcome, but alone they are inadequate to stop FTDs completely. The SEC (or Congress) must take the following simple, easy to implement and fair steps:

• Impose a requirement that prior to a executing a short sale, a seller must have a legally enforceable right to deliver by the delivery date the shares that are to be shorted (as required in Japan, Switzerland, Hong Kong, etc.).
• Enable transparency by requiring timely disclosure of true volume of all failures-to-deliver (including those that occur “ex-clearing”).
• Provide for cradle-to-grave trade tracking that links FTDs to their source (rather than net settlement).
• Require forced buy-ins of FTDs (as is done in Canada).
• Make permanent its interim hard-delivery requirement.
• Actively enforce these rules, including levying significant monetary penalties.

Members of Congress, the American Bankers Association, academics, public companies, and the U.S. Chamber of Commerce have urged the SEC to accept some or all of these proposals