Naked Short Selling Is a Phoney Problem

John Hempton has an outstanding post on the government's absurd war on naked short-selling. He says that it's costing taxpayers one billion dollars.

It's a long post; here's a sample:

The story was that selling stock you did not own was producing “counterfeit shares”. I have yet to see mischievous naked short selling of any real business – though I have seen some fails-to-deliver (that is not actually being able to borrow the stock on the delivery date) remedied a few days later and with all obligations to the exchange cash collateralised over the interim period. There were plenty of “fails” but no real naked short selling “problem”. Hard to borrow stocks did fail regularly – but I assure you – and I have been doing this for years – when there were fails to deliver my broker called my short back and hey – presto – a few days later I had settled. If there was a “counterfeit share” it was cash collateralised and it was cancelled a few days later (in exchange for the cash collateral). The person who purchased the share from me got all the economic benefit of owning that share – and a full voting share was delivered to them within a modest time.

Fails to deliver now are – with electronic settlement – a far lesser and far quicker remedied problem than they were in the days of paper certificates. And with the speed at which they are settled – and the ability to demand cash collateral when a party fails to deliver they cause no economic problem at all.

The SEC has now forced shorts to find a borrow before you can actually short the stock. Hempton points out the harm in this in the case of Citigroup (C). You can buy Citigroup at an 18% discount by buying the preferred. So there's an arb play; long the preferred, short the common.

Well, now you can't do that with certainty. If you short Citi, you might be forced to buy it back at a higher price. As John points out, who is Citi's largest shareholder? Taxpayers.

So – in pursuing the bogus issue of naked short selling not only has the SEC diverted resources from its real job (which is chasing the real crims in the financial market such as Madoff) but it has imposed significant and real costs on the taxpayer and made it harder and more expensive for banks to raise capital in a financial crisis.

But – I should not complain. It has put a reasonable risk arbitrage our way – and I hope to report back that – thanks to the SEC crackdown on a bogus issue our clients are just that little bit richer.

Nonetheless I will know a commentator who really gets it when they defend modest levels of cash collateralised fails to deliver as a normal part of a normally functioning financial market. Naked short selling is good for markets, good for taxpayers and good for capitalism.

Disclosure: No positions

Comments

[Phil Trupp:]

For years the shorts and naked shorts have pulled value from the markets and from the economy and the results are painfully obvious. Shorting to bankruptcy is, indeed, the dream. As a pricing tool, shorting has become vicious in this predatory environment. The position of being a fulcrum in the process of arbitrage has long been abandoned. We now have wolf packs with a refined taste for blood.

Jun 17 12:51 PM

[Northstar10000:]

Phil
You have no idea what you are talking about. Sounds like you are an Obama economist. The article is correct. Sorry the emotion of your post says you are clueless. Bet you can't give even one example of a viable company naked shorted to death. Don't even think about the question, it is way beyond your ability to think. Naked shorting may only take out companies that were going under anyway but common sense tells you something of value can not be artificially held down. Hedge funds and large trading desks make a living out of finding miss priced securities. They can make a killing off even a 1 percent miss priced model. save your emotion for the Obma team meeting.

Jun 17 08:32 PM

[Blair:]

My opinion regarding naked shorting is that it is equivalent to horse thieving.

In other words, selling something that you don't own. In the old days, they would hang the thief from the nearest tree. Perhaps they should go back to the old days. If nothing else, make it a felony with a one year minimum sentence.

There is nothing wrong with legitimate short selling, where the short seller borrows stock to short. Indeed, it helps market liquidity.

Further, as a statement to Northstar 10000, the last thing that I am is an Obama supporter.

To close, there is one thing that brings joy to my heart is when I read another hedge fund goes under. In German they call it schadenfreude.

Jun 18 02:59 AM