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Continuing with the theme of naked short-selling, I have a video that was given to me last week that will allow people to see how naked short-selling can take place.
This video is only 31 seconds long (scroll on down to view it), and what it shows is a day-trader trying to sell short shares in a major NYSE-traded stock. To disguise the identity of the trader, I’ve had to edit out the name of the company in question — I’ll call it BANK X for short. What I can say is that the stock in question is one of America’s largest financial companies and the recipient of an enormous amount of public bailout money, so the fact that its stock can be manipulated is something that should be a concern to everyone.
In the video, which believe me doesn’t look all that sexy, the trader is using an online trading platform. His clearing firm is a company called Penson Financial Services, which, though not particularly well known, has in recent years suddenly become (by volume anyway) one of the biggest such firms in the country.
A quick aside, before I get to the specifics of this video. My recent Rolling Stone article doesn’t talk much about day-trading, which in retrospect is probably too bad. Day-trading is an increasingly large percentage of all trading on Wall Street, and day-traders have a unique ability to impact the value of stocks via naked short-selling. One the big reasons for this is a loophole in the existing rules governing naked short-selling, called Regulation SHO or Reg SHO.
As it stands, when a day-trader puts an order in to his broker to make a short sale in this or that stock, the broker does not have to actually locate those shares right away. Instead, all he has to do is have “reasonable grounds” to believe that he can locate those shares. Here is how the rule reads, even now, even after the so-called “tightening” of the Reg SHO rules last fall:
Reg SHO “requires broker/dealers, prior to effecting a short sale, to borrow or arrange to borrow the securities, or have reasonable grounds to believe that the securities can be borrowed so that they can be delivered on the date delivery is due.”
Now, this is already a very funny piece of regulatory policy — asking greedy-ass financial companies to determine what to them is a “reasonable” effort to follow the rules. But it gets funnier when you throw the peculiarities of intra-day-trading into the mix.
Say you’re one of those big brokers, and you’ve got a day-trader who wants to make a short sale. You know he is going to close out his position by the end of the day. You know, in other words, that as far as he’s concerned, you’re going to be net flat by the time the business day ends.
Under that standard, a “reasonably” greedy broker might just determine that any amount of any security can be approved for this trader to sell, regardless of whether he, i.e. the broker, can locate it or not.
Why? Because his trader is going to close out his position by the end of the day anyway. So why bother properly locating the stock? It’s not like you’re going to have to run around three days later to find the stock to deliver for legal settlement. Your customer isn’t even holding his position overnight.
This is why Reg SHO doesn’t really work. If there was a hard pre-borrow requirement that actually forced traders to physically locate and borrow shares before they sold them, you wouldn’t have this problem. But what they have instead is a system that leaves three days of wiggle room. As it stands, shares must be delivered within three days after the sale, or else the clearing firm must buy shares to close out the failed trade.
But for a day trader, none of this matters. You’re buying and selling within the space of one day. Who gives a damn about three days?
These big clearing firms know this. They also know that competitive advantage in getting the business of these intra-day traders depends on providing locates and providing them fast. A clearing firm that worries about the rules and whines about not being able to locate this or that stock is not going to keep the business of a lot of these day traders. So you see a lot of cut corners.
This video is an example of a cut corner. A second-by-second explanation:
:00 If you look at the display in the first seconds, you will see that the customer is trying to sell 100 shares of BANK X short. You can tell it’s a short sale by the purple box near the top marked “Short.” To the left of that, you’ll see that “order quantity” is 100.
:01 Now if you look at the bottom of the display, you can see that the trade has been rejected, because BANK X that day is on the hard-to-borrow list. It reads REJ – HARD TO BORROW: SHRT 100. Without getting too technical, you don’t need a formal locate when a stock is on something called the “easy to borrow” list. But BANK X shares that day were not easy to find (without digressing too much into other complicated realms, there was something going on with BANK X that day that was inspiring lots of people to snatch up its shares). So the trade was rejected temporarily, and the trader was then forced to ask for a formal locate of BANK X stock.
:07 A prompt comes onscreen. Through this box, the customer is going to ask Penson to locate shares in BANK X. But how many shares? This is where it gets interesting.
:11 At eleven seconds, you can see the customer start to fill in the box in the middle of the prompt where it reads, “Locate quantity.” To disguise the identity of the trader, I’ve blocked out the first number in the sequence. But you can see that the number is in the tens of billions of shares. Now, the float for BANK X that day was only five and a half billion, meaning there were only five and a half billion BANK X shares in circulation. Without disclosing the actual number, I can tell you that the customer asked for a locate of shares in an amount that was at least five times the number of BANK X shares actually in circulation. Such a locate, in other words, could not possibly be filled.
:17 At seventeen seconds, at the bottom, you see that the firm Penson has now approved the trade and” located” the multibillion amount of shares. The trade goes through.
This doesn’t sound all that dramatic and as video sequences go, it sure as hell isn’t the Paris Hilton sex tape. But this is an example of how naked short-selling can happen. If you don’t need to actually find the stock before you sell it, there’s no real brake on speculative naked short-selling. If a clearing firm will give you a locate no matter how big your request is, there is no real barrier out there to stop this kind of activity.
Why does this matter? Let’s say there’s a big company that is coming under attack by short-sellers — let’s take Bear Stearns for example. Let’s say it’s March 11, 2008, and Bear stock is trading at $62, but dropping. Once the run begins and the stock price begins to fall, you might see day traders piling on. If they don’t need to actually locate Bear stock, they can simply sit there and batter the hell out of it all day long by continually selling short without locating the shares first.
The best explanation I’ve seen of this problem comes from John Tabacco, the founder and CEO of Locatestock. Full disclosure: Tabacco’s company offers services designed to avert the problems of naked short-selling by using a new technology (invented by Tabacco) that provides real and legal locates to traders. So he has a financial interest in outlining these problems. He’s also a garrulous right winger who has a Sean Hannity-style TV show and probably doesn’t agree with me about anything outside finance. But he’s a great guy and has taken a lot of time to talk to me about Wall Street in recent months.
Tabacco gave a speech about this issue back in April in which he talked about the effect of day traders repeatedly hitting a stock without locating the shares first. He speculates that some of this played a role in the Bear and Lehman episodes, among others.
“The more artificial intra-day selling pressure is impacted on a single stock, the more the pool of real shares is diluted,” he said. This, in turn, creates a “cyclical spiral” in which the issuer’s “real shares are detrimentally harmed, and in some instances that we’ve seen lately, beyond repair.”
Again, a lot of this stuff is complicated and not only hard for people outside the finance world to follow, but kind of, well, boring as well. But it’s through these tiny regulatory loopholes, these little nooks and crannies, that the economy gets manipulated. The effect of all of these regulatory gaps has been to transform Wall Street from a means of connecting capital to good business ideas into a giant casino, where the object of the game is shaving little slices off the great flows of money as you push them back and forth using a great big toolbox of manipulative techniques. This is one of the tools.
- Portions of Album Content Provided by All Music Guide © 2009 All Media Guide, LLC.
Matt,
The main thing I’m having trouble understanding with your latest articles about short-selling is who does the paying? If I don’t actually need to find sellers to buy shares from, who is buying back the shares from me when I finish my transaction? It seems like somebody must be paying somebody else for anyone to be making money off this, but I don’t see who’s making the payouts here.
No one has the other side of the trade. The shares do not exist in the first place, the price falls because it believes that the shares exist, are forcing the price down and at the end of the day-trade, a net flat position is regained.
The difference in the price at the naked short and the end of the day price (lower) is the smoke and mirrors.
Hi Gregory,
Does that mean at end of the day a naked short selelr makes no profit at all??
The short seller makes the difference between what he sold short at in the morning, say $62, and what he bought back at the end of the day to close his position, in a falling market it would be say $55. The seller bought at 55 and sold at 62 and made $7.
Jake:
The main thing to remember with a short is that to the the marketplace’s perspective, there is no practical difference between a short sell and a regular sell. That is to say, a short sell still has to trade against a real buy. The problem is that when you (your broker) goes to settle the trade three days later (i.e. actually exchange money for shares), the shares have to come from somewhere. This is where the “borrowing” aspect comes in – in order to satisfy the buyer, you must actually deliver some shares, even if you didn’t have them when you sold, so your broker borrows them on your behalf (or you borrow them from your broker). To close out your position and realize your gain or loss, you must “buy to cover” the stock that you owed. One way to see this is the reverse of a regular “long” transaction – in that case, you buy, hold, and sell and net the difference. In the short case you sell (short), hold, and buy, and net the difference.
The trick comes in when you close your position within the same day — in that case, there never have to be any borrowed shares, because the position will be flat by the time of settlement (i.e. you will own no and owe no shares). If your broker lets you get away with it, you can easily take on (or more realistically, the market as a whole can take on) a position larger than the total outstanding shares in the stock.
Matt,
I’ve maintaned for several years that many Free Market proponents are unwitting drones of those who work to ensure that the markets are anything but “Free”. Thanks Matt, for providing clear evidence of how manipulation rules when regulation doesn’t. The image I’ve used to explain this is the Paris hotel in Vegas, where the ceiling is painted like sky while players are pumped full of oxegyn and alcohol. The scene at night is reminiscent of the Matrix movies representation of the pods, filled with humans, who power the grid. Scary stuff. I was gratified to see you use the casino analogy as well.
Free market advocates are certain that naked shorts are wrong. The problem is that the regulators are politically motivated, and can be bought with political contributions. The result is that they inserted that absurd language about “reasonable grounds”. While the brokers and exchanges probably advocated the language, they’re not looking at the long-term health of the market. Instead they’re focusing on the commission from the naked short sale. This should be a fundamental, hard and fast rule, that you have to borrow the stock to short it. I know, from first-hand experience, that you had to borrow the stock to short it in 1980. Sometimes, it took a while for your broker to locate the stock, before you could short it.
Matt, I really enjoyed the naked swindle and your bubble economy article in RS. You are doing a great service for this country. You are the only reason I have a Rolling Stone subscription. Just wondering how you feel about the mainstream press and the lack of informing the people.
Why do you think it is that the main stream media is not investigating and or covering what’s happening on Wall street?
How about the fact that the 700B TARP funds were not even used to by “Troubled Assets”. It was basically free money given to bankers who made irresponsible investments. On top of that the Treasury is not even requiring the banks to account for the money. A 700B handout to corrupt bankers and they don’t even ask what they are doing with the money!
Do these criminal bankers actually have some pull with the editors at the news networks, what gives?
Its not a bubble machine its an accordian that inflates and deflates and particuar assets are allocated to specific keys….Thats why deflatonists and inflationists are both wrong,because the level of manipulation is so broad and encompassing…. I believe they are playing Darth Vaders theme with regards to the dollar.
Excellent work. The video brings home some key points about the mechanics. To learn more about the social networks involved in naked short selling, see:
deepcapture.com/
The pioneering work here was done by Judd Bagley, Patrick Byrne, et al.
Dude — You got hoaxed. Or deliberately screwed. Or something. That video is bogus. When are you going to own up to it and explain where you got the video?
[...] Caught On Tape: A Naked Swindle [...]
Dian Tucker at HuffPo is saying you got duped, Matt:
http://www.huffingtonpost.com/diane-tucker/who-duped-rolling-stone-g_b_311141.html
[...] one of his blogs (which you can read here), Taibbi posts a video that seems to show a day trader conducting a short sale of stock in an [...]
Matt – I have no issue with you or your efforts to expose wrong-doing, but the video in question here does NOT show what you are claiming. The trading software shown is designed for licensed professional traders – not for retail traders sitting at home. I know this because no retail software asks a user to enter short share locate data, only professional licensed traders/brokers can do that.
The trader on this video tries a short sale and it is initially rejected due to the “hard to borrow” designation as you indicate. The software assumes that if the professional wants to complete the trade, they will follow the FINRA and SEC regulations and call their clearing firm for the locate. The software provides a dialogue box called “Security Located Confirmation” where the licensed professional then enters the data that confirms the call was made and the locate was given. This allows the software to send the order to the market with the proper tags on it verifying that a locate has been entered, and the software stores the locate information in a database for later audit purposes.
Note that the pop-up is not called a “Request” – it is a “Confirmation” that indicates the locate of the shares took place via telephone or email or IM. The licensed trader is required to follow these locate rules and can lose his/her license if a later audit determines that these rules were violated. Maybe not a severe enough penalty, or maybe not sufficiently enforced, but that is a different issue.
When you indicate in your synopsis that at :17 “the firm Penson has now approved the trade and located the multibillion amount of shares”, that is incorrect. What has happened is simply that the user has entered the data claiming that the locate was done, and clicked “Send With Info” which indicates that the order will be sent to the market with the locate data tagged on it.
One more note, the order is rejected at :27 in the video due to an error related to exceeding the maximum allowed position size. This is not really relevant to this discussion as it is just a “fat-finger” protection mechanism designed to stop orders that might accidentally have more zeroes on the quantity than were intended.
I believe that the problems of naked short selling are real and important, but we need to stick to the facts and be sure the evidence is rigorously presented for the debate to be effective.
ATTENTION: There is nothing new in history.
We are living in a country that is very similar in politics today to the Weimar Republic in Post WWI Germany.
A small faction has usurped our resources and political power (look at the votes on healthcare and the donations received by each government official from the insurance
lobby to touch the tip of this iceberg).
The Democratic Party must be reworked and reinvigorated or
A third Party needs to be brought to power before this democracy is further eroded.
If not, see you all in the South of France.
ciao
you missed out 0:26 in the video a screen pops up saying maximum position violation. ‘Under would exceed the maximum position for the account’. The trade looks like it didn’t go through…… Please explain as this doesn’t look like a smoking gun… alas
Matt,
I am fascinated by your articles in RS, and I look for them first every month. I believe that you are right on target with your investigations into the monetary market in the US, and I don’t limit the cause of all of this to the Republicans (though I would like to) but to the greed and power of the lobbyists, and Congress in general.
What sickens me the most is that mainstream media will not touch this, and the Justice Department seems obvlious to it also. Thanks for what you do, and please keep us informed.
You are doing a huge service by exposing this fraud which threatens the foundation of our financial markets.
Real video or no, that’s not the issue.
If it’s accepted, in fact, that this kind of “naked short-selling” exists and in large, dangerous quantities, how soon until a representative in Congress comes forward with a bill to make this blatantly illegal and with tough punishment for it, too?
That’s what we need. That, folks, is the issue.
It’s also interesting to note that several years ago, the CEO of Overstock.com got into a verbal war with the powers that be over the issue of naked short selling. at the very beginning, CNBC and the WSJ loved the guy, saying he was a straight-shooting maverick whose style had led to his company’s success. But when he started being a threat, he quickly became a high-maintenance whiner who couldn’t hack it in the rough and tough world of public companies.
This stuff’s been going on for a long time.
This is great writing, independent of the content. Well constructed, a skillfully developed story, and good use of language and grammar, all skills not found so often these days.
Then, of course, there is the content. One of the marks of a genuine hero is doing something no one else seems to be doing, for one reason or another. I wonder how much of this information it will take before we actually begin to make the changes we need to make.
The “Republican” party has devolved into a criminal operation, and the “Democrats” aren’t much better. With the melting of the Polar ice caps, the erratic weather, the spread of forest fires, drought, flooding, blizzards, soil erosion, and the depletion of the seas, what goes on at the governmental level can be called escapism at best, sociopathy at most likely, and suicidal as pending result.
We will change, one way or the other. At least with writing like this we have some hope of facing truth.
Hi,
I traded a system from 2003 to 2006 through MB Trading that used Penson Financial as a clearing firm. I moved several million in trades however lost a net of about $80k over that time. The system was based primarily on a buy signal of a heavily shorted stocks. If I was not being delivered true shares, this would easily explain why my system failed even though it back tested well.
My theory (albeit conspiracy) as to failure is that the “back end request for shares” by Penson Financial could actually be used as an indicator used by larger firms. For example Penson requests 100 shares of XXX at close of a day. This tells other folks (or less sinister computer models) who have the back end data that a historically weak handed day trader has a particular position in stock XXX.
Can anyone say whether this is possible and/or illegal?
Thanks,
Chris ( c h r i s 5 6 3 7 @ pacbell.com )
Sorry, previous post reply to pacbell.net not pacbell.com
I wrote the below article in March 2008 with updates later. It looks like Matt used much of my article as the basis of the Bear Stearns part.
http://www.optionsforemployees.com/articles/article.php?id=130
I have to say that the idea that Naked Short Selling brought down Bear Stearns is 100% bullshit and I completely distance myself from that idea.
Its easy to prove that “naked short selling” played virtually no part.
John Olagues
Your article is worthwhile reading.
up or down
in trading
is like red or black on the roulette wheel
it doesn’t matter
for every buy there’s a sell. For every sell there’s a buy. For every naked short seller there’s a buy at the other end of the trade
companies rise and fall on the strength of their businesses and their managers – not because of shorts.
Shorts are just traders betting on the market, sometimes to get insurance to cover their long positions.
they cannot drag a company down or hurt its dividends
if a bout of naked short selling makes a share price artificially low, then buyers looking for value will buy shares pushing the price back to equilibrium.
If share prices crash from naked shorting and don’t recover it is because something is wrong with the company and the price would have crashed anyway.
Shareholders used to buy shares to get dividends. If a company pays good dividends then shareholders will rush in when cheap as they’ll get a good return.
Now it’s a casino.
So red or black, up or down – it’s irrelevant!
A far worse way of robbing shareholder wealth is when
oops – a far worse way of robbing shareholder wealth is when company management issues thousands or millions of new shares on market, diluting shareholder value.
They do this all the time. It is robbing shareholders blind.
That is how real shareholder value is ruined, as measured by the percentage of profits the owner of the share gets paid.
the more shares they issue, the smaller my dividend cheque will be…. and the less my shares are worth on the market.
I am really loving your blog, the writing style and even the comments are reasonably intelligent.
I like your investigation into bear stearns, it was really interesting and I can see you are probing short selling and getting your head around it.
But short selling – including naked shorting – isn’t and never was the problem.
It didn’t cause any business to go bankrupt.
Bad company management did that – and a do-gooding Government/Fed reserve meddling with the system:
1) relaxing regulations so poor people could own their own homes by borrowing without first learning the hard lesson of saving and budgeting – causing sub-prime toxic loans to be made, and
2) Alan Greenspan’s Federal Reserve seeking to ride to the rescue every time a problem in the markets loomed – pumping excess liquidity in response to the Russian Rouble crisis, Long Term Capital Management failing, pre-emptively to ward off Y2K problems and after the tech crash.
Keeping interest rates artificially low to help after the tech crash also harmed the system.
All that excess money chasing a home…. inflated a housing bubble.
That is what really fucked the system.
And naked shorts have no power to ruin a company from selling a bag of cement or inventing a new widget – and if they produce a respectable profit, have good accounting practices, don’t get into too much debt and pay a good dividend then they are immune pretty much to market distortion as if the shorts run the stock price down, investors will get a good bargain and buy up the shares. The shorts will get squeezed and back off.
So: very interesting (have read your site a couple of times now), very well-written, but I think you are charging off in the wrong direction in your attempt to nail the villains.
Kudos Kudos Kudos
A beautifully written macro Matt.
The roads back to all the important resolutions point
squarely where we all expected them to be.
Certainly all of our early theories have been proven and
somewhat verified.
Clearly the story of John Fierro is louder and more
relevant now than ever. Is it possible that the epicenter
of equity ‘hoodwinking’ started there?
It seems so unlikely!