Naked In Wonderland [another unregulated Wall Street gambling ploy]

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Our financial system is rife with unsettled trades that are deliberate and massive -

Concerns about short-selling have culminated in a regulatory flurry of emergency orders and amendments. What should be of concern, however, is not short-selling per se: As its devotees frequently remind us, short-selling is a vital and legitimate market activity. What should be of concern are specific types of stock manipulation that cloak themselves within legitimate activities such as shorting, and which, in one way or another, rely upon loopholes in our nation's system of stock settlement.

"Settlement" is the moment in a stock trade when the seller receives money and the buyer receives stock. Our settlement system has gaping loopholes that allow sellers to sell shares but fail to deliver them. In such cases, the system creates IOUs for shares, and lets those "stock IOUs" circulate in the expectation the seller will soon correct his error. This is harmless--as long as the IOUs are inadvertent, temporary and few.

Manipulators are exploiting these loopholes, however, selling stock they do not intend to deliver. This is often referred to as "naked short-selling" (short-selling because they feign selling borrowed shares; naked because they don't really borrow shares, but instead deliberately rely on loopholes to generate and hide stock IOUs).

However, naked short-selling is just one form this manipulation takes. Other forms include failed long-sales, abuse of the option-market-maker exception, failed offshore deliveries and ex-clearing abuses. The common denominator of these manipulations is that they flood the system with stock IOUs that are deliberate, persistent and massive.

The small problem is that stock IOUs corrupt corporate democracy because the system has trouble distinguishing real stock with real votes from stock IOUs with fake votes. The medium problem is that manipulators selling millions of stock IOUs drive down share prices: If they choose the right target (e.g., a large financial firm already weakened by exposure to the mortgage crisis, or a small biotech company sipping at capital as it develops drugs), this can crash the firm.

The large problem is that unsettled stock trades create systemic risk. Imagine that a hedge fund generates IOUs on 5 million shares of a $1 stock and carries this as a $5 million liability. To settle these IOUs, the fund must obtain stock. However, the act of buying 5 million shares of a thinly traded stock forces its price up (i.e., a "squeeze"). The fund must pay more than $1 per share, so the $5 million liability balloons.

The Securities and Exchange Commission has revealed that, during the second quarter of 2008, there were $14.9 billion in stock IOUs at just the tip of the non-settlement iceberg. The commission refuses to reveal (and, in fact, may not know) the size of the whole iceberg. Public data suggests the entire bucket may be over $150 billion; settling it would cost more than $150 billion, but perhaps far, far more.

When these loopholes began to be exposed this winter, Wall Street started to eat its own. In a moment of Shakespearean irony, Bear Stearns--with its legendary willingness to provide cover to manipulative hedge funds--became the target. Stock IOUs in Bear Stearns spiked, as they subsequently did in Lehman Brothers, Merrill Lynch, Fannie Mae and Freddie Mac.

Our financial system is rife with unsettled trades that are deliberate and massive -

Concerns about short-selling have culminated in a regulatory flurry of emergency orders and amendments. What should be of concern, however, is not short-selling per se: As its devotees frequently remind us, short-selling is a vital and legitimate market activity. What should be of concern are specific types of stock manipulation that cloak themselves within legitimate activities such as shorting, and which, in one way or another, rely upon loopholes in our nation's system of stock settlement.

"Settlement" is the moment in a stock trade when the seller receives money and the buyer receives stock. Our settlement system has gaping loopholes that allow sellers to sell shares but fail to deliver them. In such cases, the system creates IOUs for shares, and lets those "stock IOUs" circulate in the expectation the seller will soon correct his error. This is harmless--as long as the IOUs are inadvertent, temporary and few.

Manipulators are exploiting these loopholes, however, selling stock they do not intend to deliver. This is often referred to as "naked short-selling" (short-selling because they feign selling borrowed shares; naked because they don't really borrow shares, but instead deliberately rely on loopholes to generate and hide stock IOUs).

However, naked short-selling is just one form this manipulation takes. Other forms include failed long-sales, abuse of the option-market-maker exception, failed offshore deliveries and ex-clearing abuses. The common denominator of these manipulations is that they flood the system with stock IOUs that are deliberate, persistent and massive.

The small problem is that stock IOUs corrupt corporate democracy because the system has trouble distinguishing real stock with real votes from stock IOUs with fake votes. The medium problem is that manipulators selling millions of stock IOUs drive down share prices: If they choose the right target (e.g., a large financial firm already weakened by exposure to the mortgage crisis, or a small biotech company sipping at capital as it develops drugs), this can crash the firm.

The large problem is that unsettled stock trades create systemic risk. Imagine that a hedge fund generates IOUs on 5 million shares of a $1 stock and carries this as a $5 million liability. To settle these IOUs, the fund must obtain stock. However, the act of buying 5 million shares of a thinly traded stock forces its price up (i.e., a "squeeze"). The fund must pay more than $1 per share, so the $5 million liability balloons.

The Securities and Exchange Commission has revealed that, during the second quarter of 2008, there were $14.9 billion in stock IOUs at just the tip of the non-settlement iceberg. The commission refuses to reveal (and, in fact, may not know) the size of the whole iceberg. Public data suggests the entire bucket may be over $150 billion; settling it would cost more than $150 billion, but perhaps far, far more.

When these loopholes began to be exposed this winter, Wall Street started to eat its own. In a moment of Shakespearean irony, Bear Stearns--with its legendary willingness to provide cover to manipulative hedge funds--became the target. Stock IOUs in Bear Stearns spiked, as they subsequently did in Lehman Brothers, Merrill Lynch, Fannie Mae and Freddie Mac.

Original URL Click to Edit

http://www.forbes.com/opinions/2008/09/23/naked-shorting-trades-oped-cx_pb_0923byrne.html

http://www.forbes.com/opinions/2008/09/23/naked-shorting-trades-oped-cx_pb_0923byrne.html