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Revision as of 21:55, 28 January 2006 by 201.124.135.229 (talk)(diff) ← Previous revision | Latest revision (diff) | Newer revision → (diff)A naked short sale, (or naked shorting), is the practice of creating a sales transaction, debiting the buyer's account, and then failing to deliver the product (the share). Generally an illegal practice, it is legal in some limited instances: for market makers, and in some hedge transactions. But it is generally accepted that taking a customer's money, and not delivering the product, is simple fraud.
The practice is often confused with legal short selling, which is unfortunately due to the nomenclature. Most now refer to naked short selling as the SEC and the industry does, which is "Failing to Deliver".
In a legal short sale, the short seller borrows a share of stock, then sells it, in the hopes of buying it back at a lower price when it is returned to the lender. In this legal short sale, the buyer of the shorted share receives a real share, albeit one which was borrowed. This is a legal and acceptable way to bet on a price decline.
In a naked short sale, the short seller never borrows a share, and advertises a false share for sale. The buyer "buys" that share, his account is debited the money for the purchase, all the brokers are paid their commissions, but then the share is not delivered. This is possible due to Wall Street's divorcing clearing (payment and processing of the transaction) and settlement (actual delivery of the share).
Critics of the practice maintain that advertising something for sale, and then failing to deliver it after the transaction has gone through, is fraud. Apologists for the practice generally don't argue this seminal point, but rather claim that it is a minor problem in the markets, or that it counters other frauds, or that it is useful because it provides liquidity.
The amount of naked short selling fraud in the US markets is a closely guraded secret, specifically because the SEC refuses to provide definitive numbers. They do admit that 1% of all transactions per day do not settle, which is generally accepted to be a $6+ billion per day issue, highly concentrated in a small number of stocks. In late 2004, the SEC passed Reg SHO, in order to bring some balance to the markets, and in the process "grandfathered" all instances of naked short selling prior to 2005 - causing critics to argue that the SEC had just created state-sponsored fraud, as untold billions of dollars of transactions, for which no product was ever delivered, were absolved of the requirement to ever deliver any product. The SEC refuses to disclose how many billions of dollars were grandfathered, or how many shares. They also refuse to disclose the amount of naked short selling in any given company, causing critics to claim that the SEC is de facto protecting fraudsters at the expense of investors.
Advantages for the market of naked short selling
As seen in the first section, illegal naked short selling is fraud. It is the creation of a sale transaction, for which the buyer's funds are taken, but no product is delivered. Apologists for the practice seek to introduce a number of straw man arguments, none of which address the core fraud in the practice, which as noted before, is illegal in all but a few instances - such as market maker exemptions.
It is difficult to argue with a straight face that there are benefits for the market to be had by defrauding investors, however that doesn't stop the perpetrators of the practice from advancing arguments supporting the practice. Some common arguments are that naked short selling is good for the market, as it can be used to combat other fraudulent activity, such as pump and dump schemes, where promoters pump a stock's value above fair value. It is simple to see the logical fallacy here, as it really argues that one fraud can be countered by allowing a different fraud - the "two wrongs make a right" fallacy.
Another canard that is floated by apologists for the illegal variant is that it increases liquidity, which is an argument that says that by increasing the amount of fraud, you increase the amount of trading, which increases the ability to buy and sell easily, and decreases spreads. Again, this argues for allowing investors to be defrauded, as the benefits to an efficient market in trading these frauds are supposed to outweigh the damage from the fraud itself.
Current legal naked shorting rules allow brokerages to make large profits doing "bona-fide market making" while stock markets are falling. The market maker exemption to the rules governing the practice is intended to allow market makers to naked short sell on a very temporary basis, in order to increase liquidity and stabilize markets. When this practice extends for more than a few days, it too crosses over from the legal variant, to the illegal variant - fraud.
Disadvantages for the market of naked short selling
Naked Short Selling is fraud, thus the disadvantage for the market is that investors are defrauded on a regular basis by predators who use the illegal practice for financial gain. Aside from this large, obvious disadvantage, other negatives arising from the practice involve dilution of voting rights (fraudulent transactions, represented to the buyer as having been delivered but in fact un-delivered, lead to over-voting, which dilutes holders of genuine shares), price manipulation resulting from oversupply of sales transactions without corresponding shares to deliver, and loss of faith in the integrity of the market system (as investors learn that they are being defrauded at an unknown level while regulators conceal the hard data).
Controversy
There is no controversy over naked short selling being fraud. No argument has ever been successfully mounted to explain away the basic deception involved. The controversy surrounds the arguments advanced by the two camps: Those who benefit from the fraud being perpetuated, and those that are harmed by it.
Pro-naked short selling:
Members of the Wall Street community who derive their livelihoods from trading commissions are all in favor of anything that creates more commissions. These include the DTCC (the monopoly clearing and trading company owned by the Wall Street brokers and banks), Wall Street brokers and banks, hedge funds (who are generally short biased, thus benefit from their targets going down in price), the Exchanges (who receive a fee for every transaction), and many journalists who are close to the financial community.
Anti-naked short selling:
State regulators, academics, investors, shareholders, victim companies. Anyone who doesn't benefit financially from trading commissions, or stock prices decreasing.
The Arguments:
Argument 1 – Good companies aren’t hurt by naked short selling; if they are solid, the company will ultimately do well.
Fact: Defrauding shareholders is fraud, and the impact on the company is a red herring. Either you are pro-fraud, or anti-fraud – arguing that fraud ultimately won’t hurt a good company deliberately ignores that shareholders are being defrauded, and attempts to shift the discussion to a different sort of fraud – stock manipulation using naked short selling, and the long-term success likelihood of the manipulation.
Argument 2 – Naked short selling counterbalances crooked companies, and pump artists.
Fact: Defrauding shareholders is fraud, and arguing that one sort of fraud should be used to counter a different sort of fraud, is lunacy.
Argument 3 – Naked short selling isn’t a big problem – only 1% of all trades per day in dollar volume fail, thus it is insignificant.
Truth: 1% of those trades in dollars fail per day, meaning 1% of the money changing hands every day is being done so fraudulently. This fraud is not evenly distributed across the entire market - it is disproportionately concentrated in a handful of companies on the SHO list - thus a small number of companies have runaway fraud in the trading of their shares. And we have a list of which companies those are: The Reg SHO list. If the SEC would provide hard data on the actual scope of the fraud there would be no contention over the size of the problem, however they choose to keep that information secret.
Argument 4 – Not all NSS is illegal, some is innocent.
Fact: Some is. Market makers, for instance, can NSS in order to provide liquidity – temporary liquidity. When market makers NSS in order to sustain a price depression, it shifts back into the fraud area. And because some is innocent (dog ate the certificate) doesn’t mean all is – and anyone arguing that it isn’t a large problem argues from ignorance – the SEC and DTCC won’t tell us how large the problem is, and how much is fraud vs. innocent. So it could be 95% fraud, 5% innocent, or the inverse, but nobody is talking. So the question is, how much fraud is OK, and why won't anyone provide definitive data as to the exact amount of fraud that is taking place? And why, in today’s Six Sigma world, is any fraud OK?
Argument 5 – Only bad companies are victims of NSS.
Fact: Arguing that only “bad” companies’ shareholders are systematically defrauded, thus defrauding them is somehow OK, again, ignores that NSS is fraud. This argument is a variant of #1, but seeks to place the blame for fraudsters defrauding investors on the targeted company – forgetting that the company’s shares are just the vehicle being used to commit the fraud. Sort of like saying stealing from “bad” stores is OK. Makes no sense.
Argument 6 – By being anti-NSS, you are really saying you are anti-short selling, period.
Fact: This seeks to confuse a legal investment tactic with fraud, because the terms used to describe the two sound alike. Legal short selling involves borrowing a security, and selling it and delivering it to the buyer, hoping for a price decline before the seller has to buy a share in the market to return to the lender. NSS involves advertising something for sale, creating a sale transaction, debiting the buyer’s account, and then not delivering the product – again, simple fraud.
Argument 7 – NSS increases liquidity, and liquidity is good.
Fact: Liquidity is good if you are in the business of being compensated for executing lots of buy/sell trades. Liquidity is meaningless if you are an investor holding shares – it only becomes an issue when you want to sell, or want to buy. Fraud does increase the number of transactions, and the APPARENT amount of sell-side liquidity (supply) – but again, arguing that fraud is good because of the end-effects of it being perpetrated in large-scale manner, is specious. Fraud is fraud, and increasing liquidity by increasing the number of frauds is bad, for obvious reasons.
Argument 8 – Speculators should avoid stocks that are on the SHO list, as they are being warned that there is a problem – they are bringing it on themselves.
Fact: Fraud is illegal, in all instances. Having a list of companies where the fraud is massive does nothing but highlight that massive fraud has taken place. Arguing that investors should avoid buying the shares of companies whose shares have been fraudulently abused is again, blaming the victim, and while it makes sense to avoid bad areas of town where the murder rate is high, it does not make sense to condone rampant murder – anywhere. Condoning lots of murder in some areas of town, versus eradicating it, is cultural chaos. Condoning fraud in the trading of certain companies is systemic chaos.
Argument 9 – Nobody is hurt by NSS – investors can sell their shares instantly, even if fraudulently created IOUs, thus no harm done to the investor.
Fact: Argues that because the system is very efficient at trading in frauds, that fraud does no harm. Fraud is fraud, and is illegal. Whether or not a system exists for trading or perpetuating fraud does not change the nature of the crime. Property rights are protected by the Constitution, and arguing that because it is easy to defraud the next person in the chain, who buys your fraud, ignores the basic crime, and instead argues that fraud is OK as long as it is easy and efficient to commit. A completely separate absurdity is that this argument is very much akin to arguing that piracy doesn't hurt the companies being pirated, as there is a liquid market for pirated goods.
Argument 10 – NSS doesn’t impact the share price long term, as demand will eventually return a company’s stock to fair value.
Fact: Argues for price action in a stock, rather than acknowledging that NSS is fraud, and thus bad. Also attempts to introduce a straw man – company fundamentals/stock price – rather than focus on NSS, and the basic fraud committed.
Argument 11 – Getting paper certificates is foolish, or a waste of time, or will negatively impact you (difficulty in trading) or the market (decreased liquidity). Variations include arguments of low statistical likelihood of a broker failure resulting in a situation where veracity of shares is in question, or liquidity/valuation arguments.
Fact: Paper certificates are the only protection against being defrauded by a naked short sale (actually the Direct Registration System also can, but is esoteric). Arguments as to trading ease, or market valuation, ignore the effectiveness of certs as a prophylactic against being defrauded – if you have the asset in your hand, you have the asset in your hand. All other arguments are arguments against something different than the basic fraud of NSS, and seek to shift the discussion from that fraud, and how to avoid being a victim of it.
There are countless variations, but they all have the same quality: the arguments advanced attempt to ignore the basic fraud, and create straw man arguments that avoid discussion of it.
Summary
Naked Short Selling is a hot topic, as the Reg SHO Threshold list has brought to the forefront of investor consciousness the level of fraud that is endemic in the system. There is an entire financial system that benefits from increased trading, regardless of whether the trading is in legitimate shares or frauds, thus powerful forces mount arguments that seek to excuse, or rationalize, the practice. As we have seen from the arguments section, all of the pro-naked short selling positions avoid acknowledging the basic fraud, preferring to discuss virtually any other aspect of the issue. Anti-naked short selling advocates always go back to the central issue - taking money and failing to deliver the product is fraud, and fraud is bad, and illegal. A recent survey by Harris Direct showed that the vast majority of investors felt that the penalties for naked short selling should be at least as severe as those for fraud and countrefeiting - see http://tinyurl.com/82er8 for more. A list of resources has been provided below to assist the reader in doing diligence on the subject.
See also
- Bear market
- Efficient market hypothesis
- Long / short equity
- Pump and Dump
- Share price
- Short selling
- Stock market bubble
External links
............................................................... Regarding the statement "While there may be instances of abusive short selling, 99% of all trades in dollar value settle on time without incident." this leaves ONE BILLION+- dollars per day of illegal trades where there are no real shares sold to the buyers of these shares. This massive crookedness!
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