January 10, 2007
January 10, 2007
I appreciate the chance to comment on the proposed rule change.
--- Depositories are Not Banks ---
I am a believer in shorting. The person legitimately lending the stock receives a benefit - the ability to trade on margin and if done legally, the loaned stock is returned when the original owner sells his shares or requests a stock certificate. The shorting reduces irrational exuberence, while providing pent up buying demand that supports the price when the market turns bearish. There is only one legal owner of the share; the person that bought it. Only the buyer has voting rights. The lender and short do not. There is no increase in the size of the float as the lender has a claim on a share instead of a real share.
Shareholders have been demanding protection from bear raids since the SEC was formed, but the current problems with "phantom shares" are not isolated to short selling in bear raids as even long sales can fail to deliver. The issue is the system artificially inflates the float of public companies, which inevitably leads to price declines and losses for long investors.
Much of the stock that buyers think they own is not backed by real shares. The system misleads investors, providing them with brokerage statements that imply they own a share when they do not. Shareholders that own IOU's are given the right to vote when they have no real ownership in the company or alternatively their votes are discarded. When shareholders demand their certificate which must be backed by a real share, they are often stalled by an industry that knows there are often not enough real shares to go around.
The current state of the industry seems to be inspired by the banking system where accounts are only fractionally backed by real deposits. Unfortunately, they are not banks and it is fraudulent for them to take people's money without ensuring the electronic claim on a share is backed by a real share. They are there to broker a transaction and hold the asset in trust. The share is not the industries' asset and the share should not be used as collateral or encumbered in any way except by the legitimate owner, the buyer.
--- What is the Size of the Problem? ---
How are we supposed to make informed comments on a subject where even the most basic statistics are hidden from view?
In footnote 3, you say "According to the National Securities Clearing Corporation (NSCC), on an average day, approximately 1% (by dollar value) of all trades, including equity, debt, and municipal securities, fail to settle." Why do you have to quote a privately owned, for profit clearing corporation without doing your own analysis to accurately determine the size of the problem? How would they know the size of the problem when they don't clear all trades? Debt dwarfs equity in dollar volume. Why would you include debt, which presumably rarely fails with equity when doing so would skew the results to such an extent that they would be meaningless?
The problem is not limited to "fails to deliver" and "fails to receive". There are many other ways a shareholder can have a claim on a share that is not backed by a real share. The industry is allowed to treat shares as a fungible mass, equating a dollar of a blue chip company's shares as being equal to a dollar of a pink sheet company's shares and obligations are netted based on marked to market dollar values.
Are there enough shares at the Depository Trust Corporation, the Canadian Depository for Securities, Clearstream, Euroclear and other depositories to back claims on shares held in investor accounts around the world? If not, what is the shortfall? Does anyone know?
Who audits DTC participants that are clearing brokerages to see if they hold enough shares for introducing brokerages? Who audits introducing brokerages to ensure they hold enough shares for their customers?
How are netting, the stock borrow program, daisy chains of stock loans, repurchase agreements, fails to deliver and other mechanisms used to only fractionally back investors' accounts with real shares?
--- Solutions ---
If the SEC is serious about addressing this problem, which is resulting in investor losses to an industry that is not fufilling its obligation to hold real shares in trust, you will start with getting accurate information and disclosing that to investors. Lack of accurate disclosure is one reason this problem has become so large.
1. If there are not enough shares on deposit to back all of the customer claims at a brokerage, the brokerage should be required to identify that on the customer brokerage statement. Next to the position should be an asterisk and a footnote disclosing the ratio of investor claims to real shares backing those claims. There should be regular audits at all levels of the system to ensure these disclosures are accurate.
2. The concept of an OBO should be eliminated. Disclosure of personal information is not required, but the sizes of customer positions should be publicly available so every investor knows what the ratio of customer claims to real shares is. I believe the problem is extremely large.
3. Buy ins should not be optional. Brokerages should be required to automatically perform a buyin when trades don't settle. Brokerages that don't deliver real shares in response to a buy in should not be be banned from further trading of any US stock.
4. I recognize that your ability to regulate foreign entities is limited, but you can regulate domestic entities. Foreign brokerages should be required to follow US rules if they trade US stocks. If they don't, then they should be added to a list that US based brokerages are not allowed to enter into trades with.
--- Regulation SHO ---
Of course the grandfather clause should be eliminated. You should follow the securities act, which does not allow unregistered phantom shares to trade along side real ones. That said, SHO is only addressing a tiny fraction of the problem, which is that by allowing claims on shares to only be fractionally backed with real shares, you are allowing an increase in supply that inevitably leads to long investor losses and large gains by the industry and investors that use this loophole to manipulate the system. As long as the loophole exists, SHO will never stop the problem of "phantom shares".
A Concerned Investor