The Impact of Naked Short Selling and Ftds on Capital Markets
Matt Witter asked:
The primary motive of an investor in the stock market is to maximize profits. What if there was fraud in the financial system that could block the investor from maximizing their profits on a stock? It is now proven that broker-dealers withhold investors’ money and intentionally fail to deliver shares in an attempt to maximize their own profits. Only recently has its widespread effect become known to the public. Because these broker-dealers have created a massive problem, it is important to understand how it has happened and who should be held responsible.
Approximately 2.5 billion shares per day trade on the NYSE and NASDAQ exchanges. These trades settle through the DTCC (Depository Trust and Clearing Corporation), within the DTCC and directly between broker-dealers (called ex-clearing). Traditionally, the investor pays the broker-dealer money in return for shares of stock. However, sometimes the broker-dealer either does not the have the shares readily available, or something comes up where the broker is blocked from settling the shares through the system. The broker-dealer then creates an IOU in the form of stock, which settles through the system and appears to the investor as normal stock. The whole system usually views IOUs as normal stock. Several days later, the blockage may clear up and the IOU can be cleared from the system. This is what is supposed to happen, however, the broker-dealer takes advantage of the system.
A broker-dealer can take advantage of the system by consistently sending IOUs in the form of stock to the investor. Meanwhile, the broker-dealer hoards the investor’s money. This is called an intentional failure to deliver (or FTD). Naked short selling therefore received its name from fraudulent FTDs. FTDs flowing through the DTCC become like sand in the financial system, which affects supply and demand of shares in the market.
FTDs affect supply and demand of shares in the market, and it can force stock prices to decline rapidly. For example, a particular stock is selling for $50. When a broker-dealer sends more FTDs into the system, it increases the stock’s supply significantly because the system sees FTDs as normal stock. As supply increases, it forces the price down. Sometimes a stock is even forced into a penny stock. When a firm’s stock price turns into a penny stock, customers and markets both shun the firm. As a result, a price ceiling is formed at the penny stock level, and the firm cannot recover because all of the FTDs turn into penny FTDs. It is appropriate to ask not only if this can actually happen but if it does actually happen.
There is now evidence that market makers fail to deliver shares. Supposedly, this does not happen enough to break the financial system. On the other hand, people who work at the SEC (Securities and Exchange Commission) and DTCC are fighting to withhold any information containing proof of naked short selling. They are the same people, however, who claimed naked short selling was not happening before evidence showing that is was happening became known to the public. Information was released to the public through the Freedom of Information Act (FOIA).
“FOIA shifts the burdens of proof away from the citizen and onto the
governement (Byrne, 2007).”
In 2005, FOIA requests were sent to the SEC for the number of FTDs on the aggregate level and individual company level. The SEC resisted at first, but FOIA forced the SEC to release some information. In July 2005, the SEC released a partial answer. The data was given from April 2004 through April 2005, and it showed the number of FTDs out of the total trades on the New York Stock Exchange and NASDAQ. For example, on August 17, 2004, total NYSE and NASDAQ trades totaled 2.6 billion. Out of 2.6 billion trades, about 230 million trades were FTDs. In other words, 8.8% of total trades on the NYSE and NASDAQ in one day were failures. It should also be noted that the partial data released by the SEC does not include ex-clearing information, which is when two brokers deal and trade outside of the DTCC. The DTCC also gave misleading information, and its validity was challenged immediately.
In March 2005, Larry Thompson, Deputy General Counsel of the DTCC, released a statement saying:
“In dollar terms, fails to deliver and receive amount to about $6 billion daily,
again including both new fails and aged fails, out of just $400 billion in trades
processed daily by National Securities Clearing Corporation, or about 1.5%
of the dollar volume (Byrne 2007).”
Unfortunately, Larry Thompson gave misleading information, and it was brought to attention by Dr. Robert Shapiro, who served as U.S. Under Secretary of Commerce for Economic Affairs from 1998 to 2001 and was the principal economic advisor to Governor Bill Clinton in the 1991-1992 presidential campaign. In response to Larry Thompson’s statement, Dr. Shapiro stated the $400 billion is incorrect because it includes numerous other transactions processed by the NSCC. Shapiro claimed the value of all equity transactions on U.S. markets in 2004 averaged $82.3 billion per day instead of $400 billion. If this information is correct, then the $6 billion of daily FTDs claimed by Larry Thompson actually accounts for 7.3% of daily trades instead of 1.5%.
The most important aspect of naked shorting is the fact that broker-dealers deliberately fail to deliver shares at settlement. Susanne Trimbath, a former manager of depository trust and clearing corporations in San Francisco and New York, summarizes the unfair treatment towards investors by saying:
“If an individual investor buys or sells shares, the retail broker won’t tolerate any
failure of delivery, either of shares or of money. So why, then are the brokers-
dealers allowed to fail delivery of shares for weeks, months and in some cases
even years (Trimbath, 2007)?”
In response, these broker-dealers are the owners of the central clearing and settlement organization in the United States, and the DTCC is the one company that provides settlement services for every trade. Congress gave the DTCC authority to settle these transactions; however, the DTCC and SEC both say they cannot fulfill the purpose for which they are intended. Naked shorting occurs when an individual agrees to sell a stock that they neither own nor have borrowed. As a result, failing to deliver creates “phantom shares,” which may dilute the price of an individual stock (Investopedia). If the DTCC and SEC are both saying they cannot fulfill the purpose for which they are intended, and if they are the organizations that are supposed to keep an accurate record of all transactions, then where is the accountability for FTDs? Who is going to hold the broker-dealers responsible for their unlawful actions?
In conclusion, broker-dealers who have essentially stolen money from investors need to be held accountable. Investors should be able to trust their broker-dealers with their hard-earned money, and broker-dealers should remain loyal to their obligation of acting in the investor’s best interests. The SEC and DTCC should be expected to release all information containing proof of naked short selling. Larry Thompson and any other representative caught releasing inaccurate information in the past should also be held responsible. Thankfully, there is currently a ban on naked short selling, and hopefully it has ended completely; however, it is only a matter of time before broker-dealers find their next loop-hole in the financial system.
References
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[PowerPoint slides]. Retrieved September 30, 2008, from
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Dumortier, A. (2008, September 22). The Truth About Naked Shorts. In
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Kirby, R. (2006, October 30). FAILURE TO DELIVER OR “DELIVERANCE”? In
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