April 23, 2007
In the pursuit of eliminating failures to deliver, the SEC needs to address the ACAT transfer system which has a systemic loophole that can be abused.
My broker requested a delivery with a DTC transfer and it didn't come in a reasonable amount of time. He called the sending broker who told him to use an ACAT.
The ACAT system allows shares to be borrowed from the pool of shares in the Stock Borrow Program when a broker is short. There is little if any cost to borrow these shares as the profit is returned to the participants proportionally to what they pay for this.
There is no incentive to pre-borrow with such a convenient low-cost system that is available only to certain people in the market. If a client is short and the client/broker didn't pre-borrow the shares, the broker can use the SLP shares at minimal cost while charging the client market rates for the borrow. This system that was set up to maintain a certain amount of liquidity can be abused for profit by the same brokers who allow their clients to mark short orders as long. These brokers were identified in the investigation in Operation Uptick.
The broker who is short borrows from the Stock Borrow Program and has 60 days to cover. Not 3 days, not 13 days, but 60 days.
If the Stock Borrow Program actually has enough shares to borrow for the transaction, the shares are transferred to the buying broker who likely puts these shares back into the SBP.
The offending accounts/broker is still short, but has little cost to maintain the short position. In 60 days, the broker can get another broker to short him shares using the market maker exemption and then not demand delivery or he can request delivery and the process is repeated back and forth every two months.
If a buyer requests certificates or if the buyer has an account that is not supposed to be lent out, there should to be fewer shares in the SBP than are being lent out. This means that shareholders who are lending shares are competing with the Stock Borrow Program which may or may not hold adequate shares and is actually lending phantom shares.
This is just more slop in the system that makes failures to deliver more likely.
This is not supposition. OSTK was able to determine that brokers had credited clients' accounts with far more shares than existed at the DTC. Whether the fails resulted from the type of abuses that were documented in Operation Uptick where the brokers and banks facilitated fraud, stock manipulation, money laundering, and tax evasion by not monitoring their clients and the transfers, or if they happen from honest delays where stock certificates get eaten by dinosaurs, it is not reasonable to allow 60 days to clean up fails. If you remove the grandfather clause and the market-maker exemption, the ACAT loophole will used more and the actual number of fails in the system will not be cured.
The SEC could request an audit of the DTC and the brokers on all the stocks who are on the threshold list just as OSTK did. These results should be published and the volume of shortages at various brokerages should be broken out. This investigation and the ensuing transparency would aid the SEC in curbing fails and cleaning up the market. The threshold list has become a black eye for the SEC, the market and our country. It shows that there are companies that the SEC will not protect from fraudulent trading.
If the SEC does the job which is mandated in the Securities and Exchange Act, there is going to have to be a complete overhaul and investigation into the loopholes and rules that allow failures to exist. The standards of measure are even suspect as failures are measured in mark to market value and the exchanges don't report the amounts that represent companies that get de-listed from their exchanges or get bankrupted by their capitalization being stolen by those who use the loopholes to counterfeit stock and represent share entitlements to buyers as bonafide shares issued by a company.
Please do not delay in eliminating the grandfather clause and the market maker exemptions, but be aware that the Stock Borrow Program is another place that fails can persist and monitor its use and abuse.