April 29, 2007
Naked short sellers are simply using the laws of supply and demand to steal from the investing public. It is critical that the Federal Government ensure that the markets are safe from this kind of abuse and prevent failures to deliver.
In any market where the number of commodities (in this case, stocks) are fixed, the price of that commodity is dictated by the demand. Demand is never constant, but the supply of a company's stock is supposed to be fixed at all times unless and until the company reports, publically and in advance, that more shares are being issued.
But if the supply of shares can be artificially increased by naked shorting, the equation changes. The investing public is put at a disadvantage because there is no transparancy in the number of shares actually trading.
In simple terms, if demand were constant then if the supply is increased the price will go down. And that is how naked short sellers are abusing the markets to steal money from the public, our mutual fund investments, our 401Ks and other holdings. They increase the supply and gain from the decrease in value over time.
Even if demand increases, the price will not rise to a true equilibrium price because the supply is being increased without public knowlege. And eventually when demand tapers, the increased supply makes stock declines that much more dramatic.
In essence, the advantage is at all times to the naked short seller. He never needs to deliver shares even if the price is rising, so when demand increases he simply increases the supply further, fulfilling that demand with artificial shares to mitigate his paper losses. Eventually demand will taper off, and the artificial increase in supply causes the price to fall greater than it would have had the supply never been artifically inflated. Thus, increases in demand are just more opportunities for the naked short seller to gain.
All this was supposedly designed to provide liquidity and prevent volatility. But in practice we see that it is being abused. It prevents volatility only to the upside but creates greater downside volatility and velocity when demand is reduced. This is why the advantage is always to the naked short seller. Since Market Makers and Prime Brokers are the only ones technically able to naked short, they have no incentive to provide price stability on downward moves.
I propose the following solutions:
- The Market Maker exemption must be eliminated immediately. It is too easy for sophisticated investors to abuse and creates a gigantic financial incentive to manipulate the supply in order to collect options premiums.
- Reg Sho listed stocks must be put on a "Do Not Short" list. Only long side sells must be allowed on all Reg Sho listed stocks. This "do not short" must apply to market makers especially, as they are often just divisions of large investment banks that extend the credit and earn commissions from hedge funds.
- Future short sales must settle in T+3, or else a mandatory buy in must occur automatically by T+5.
- The implementation of a system that will prevent the shorting of already shorted shares.
- Full and real time transparancy for all markets including short interest. The derivatives market also needs to have the same transparency as the exchanges.
- Long interest disclosure should be reduced to 2%, and short interest disclosure should be instituted at 1%. Thus, if any entity is short more than 1% it must be disclosed to the SEC.
- Options positions should be included in the reporting rules. Thus, a long or short position comprised of shares and options or other derivatives that is greater than 2% or 1% respectively must be disclosed.
- Reduce the disclosure period from 30 days to 5 days. This is particularly important because hedge funds are keen on taking large put positions after they have accumulated a large short position, to force market makers to short more shares.
- A new investigative unit at the SEC charged with monitoring sell side analysts and the positions their brokerages may have at any given time. The current disclosure statements are inadequate.
We have a large problem because banks, brokerages, market makers and sell side analysis are all cohabitating under the same roof. The relationships among them have become too cozy, and is now extremely suspicious to find that brokerages seek hedge funds as clients, issue reports for public consumption and operate market maker desks all at the same time. It clearly is ripe for abuse without more transparancy. Without pointing fingers at anyone, the bottom line is that the SEC must look at how these relationships can be abused and close those loopholes.
The SEC should not settle any disputes internally. All disputes should be referred to the Department of Justice and prosecuted independently. The SEC needs to investigate thoroughly and provide evidence, but cannot and should not be the judge and jury as well.
One way to help would be to make the DTCC a public entity and bar settlements from occurring outside this arena. All trades must go through one place, where trade data information can be made available to the public without necessarily disclosing who is doing what when. While this may increase costs slightly, the price is well worth it if it provides more security for the investing public.
Thank you for your consideration.