The SEC's Campaign Against Naked Shorting: Misguided or Right On?

To the extent that the SEC has evidence that naked shorting is going on, then more power to 'em to try to put an end to it (but if so, why limit the new regs to only 17 stocks? Get rid of all of it!). I'm somewhat skeptical, however, that naked shorting is widespread and had much to do with the declines in the stocks of the 17 companies.

This belief is rooted in the fact that not only have we never naked shorted -- our prime broker I'm sure wouldn't allow it, even if we wanted to -- but in nearly ten years in this business, I've never known of or even heard of a case of naked shorting.

But maybe I'm just naive or only hang out with honest people, given that the stocks of these companies have jumped probably an average of 30%+ in the past two days. It was a classic short squeeze, and there are a number of possible explanations for it:

A) I was wrong and there was, in fact, a lot of naked shorting -- and when these people rushed to cover, the stocks soared. If this is true, one friend hypothesized that it might have been the prop desks of the Wall St. firms that were doing the naked shorting, knowing they could always call in the borrow from their hedge fund clients if necessary. I've seen zero evidence for this, but an interesting hypothesis...

B) The SEC's new regs were a major contributor to the big move, but not because there was actually a lot of naked shorting. Rather, because nobody knows how much naked shorting these is, legitimate shorts feared there might be a lot of naked shorts rushing to cover, so rushed to cover ahead of them.

C) The run-up would have happened anyway, even if the SEC hadn't issued the new regs. Financial stocks were oversold, every momentum nitwit (and there are A LOT of them) was long oil and short financials, Wells Fargo had a good report, etc.

My guess: 10% A, 40% B and 50% C.

Comments

[Briggsy]

You should talk to the CEO of Overstock.com. He is obsessed with the problem to the point of paranoia.

[user225084]

Another guess: A-B-C is 0-100-0.

This is pure manipulation by the SEC, They are simply trying to frighten the shorts, and they are doing the bidding of all the financial firms that realized that too many people were getting in on a game that they like to have for themselves. And this time they were themselves on the receiving end of some very well deserved shorting, so they wanted to create a psychological barrier to shorting.

Think of it as a truce among financial companies: No more shorting of each other, and frighten the rest of the world not to short them as well.

It won't work in the longer run.

[John DoyleRipper]

If naked shorting isn't a serious problem and hasn't been putting big money in some pockets then why all the whining about the new rules?

[Annie Trust]

Thanks for the article --

I was unaware it was 17 companies. Why is making a special rule for 17 companies legal? Last time I checked we had a Constitutional Equal Protection clause -- you can't make laws picking only on individuals.

Be that as it may. . .I don't think these amorphous markets should be banned, just transparent.

I think you make an important point: With *unreported* naked shorters around (and dark pools), the public equities markets are now on-line gaming casinos. It's a guess - you don't know the value of the shares because you don't know the volume traded and you don't know the liquidity.

The regs should require that naked short contracts be made public, along with the number of shares or other instruments traded in dark pools.

[pelican]

I liked your % breakdown guess and agree with the reasons for the spike in financial stocks. I have to wonder though...if naked shorting is effective (i.e. good return) then the % is much higher. Sounds a bit cynical but where there are above-average returns to be made, and if the risk of being caught is perceived to be low, its probably more widespread than most of us realize.

[Annie Trust]

Wait . . now there's a report that Market Makers are exempt presumably for administrative reasons (they have to borrow the shares to match the buy and sells or something like that). Is this a full exemption for everything? Hmm.

Pelican may be on to something, higher % returns, this is going on much more than we know.

SEC? Hello?

[imt]

I am yet foggy over the whole "naked" aspect with regards to companies with shares as accessible as Citigroup and others in its class. As soon as this rule was announced, Fidelity disallowed shorting on all big named financial and brokerage stocks. Period. When I inquired as to whether they had been participating in illlegal activity by allowing sales of shares they could not deliver within a reasonable length of time they gave me a round about answer as to it being a 'corporate decision concerning the health and stability of the overall market'.
What it amounts to is stocks only being able to trade higher because the SEC stepped in and eliminated the balance system. No matter how horrible the news most financials will now pullback temporarily only to inevitably head higher.
This action by the SEC should be deemed illegal.

[user225084]

Not all brokers are disallowing shorting the dirty 19, but some require that you enter the order anew every day. Ameritrade is one of them. In any case, the restriction is in place only until July 29, it will soon be back to normal again.

The effect is purely psychological.

[glassbox]

This blog is full of shorters. No one has yet written anything to acknowledge that shorting (naked or not) is a derivative. I've hightlighted so many times - its a derivative, premised on a shareholder's willingness to lend. So in this country, have shareholders been asked? SEC has not addressed this. And because of that, traders/speculators/he... funds have conveniently used this loop hole to short stocks. And now they are whining and claiming that shorting makes the market more liquidity.

I can say leverage makes the market more liquid too. Borrowing shares to short is just another form of leverage, and all these shorts who keep blaming the banks and SEC for allowing excessive monetary leverage are just now getting a taste of their own medicine. I call on all shareholders to pull the plug under these shorts by asking for your shares back. If these traders are so smart as to call for day of reckoning of excessive leverage, its time that they also start to feel the pain of their callous excessive risk taking at the expense of the longs.

[Kinabalu]

Naked shorting has been around for years. The SEC has said they don't have the manpower to enforce the law. The political noise from the big financial institutions, whose stocks were dropping like rocks, just got too loud to ignore any more.

You say you've never heard of a case of naked shorting. An author here on Seeking Alpha was recently bragging about his naked shorts. See the eighth comment under the article.

seekingalpha.com/artic...

[bearfund]

I'll take (C). We were extremely oversold and a lot of good companies had taken beatings that were not justified by fundamentals. Of course, a lot of companies whose shares are short to zero candidates were doing better than they should, but that's neither here nor there. The SEC's guidelines are BS; naked shorting has always been illegal in any issue and it would not hurt the market a bit to enforce that rule. Shorts have a legitimate place in the market and everyone needs to acknowledge that. But they also need to borrow the shares they sell. Failure to deliver should result in an automatic loss of one's seat on the exchange. That would put an immediate stop to naked shorting. And this should apply to all issues, not just the chosen 19.

[redhotmedia]

Or...

D) You are in bed with a monster hedge fund which uses naked shorting as a strategy, and your handlers have told you to write a piece denouncing any regulations over it.

[gigem77]

10 years in the business and you've never heard of naked shorting... wow. Look up Reg Sho and "fails to deliver". Ask the Taser folks about their annual meeting where 80 million shares were voted and their float is only 60 million. Naked shorting creates counterfeit shares and the practice is widespread. The SEC allows naked shorting by market makers in order to maintain liquid markets. But the practice has been greatly abused.
Listen to the Bud Burrell interview at www.financialsense.com...
Jim Puplava has done a series on the subject and it's all archived at his site under "Crime of the Century".

[Takayama]

I believe a group of people are always monitoring the total shorts in the market, and just waiting for the right moment and favorable conditions to do a short squeeze. The same applies for all the long trading positions.

All trading positions are stored in computer databases. It would be extremely lucrative to share these databases.

I read a post in an Australian forum on bet hedging by some CFD providers. It was mentioned the gain for their clients translates to a loss for the providers and vice versa.

Further mentioned that the average CFD trading account is depleted within a few months.

[AmesTiedeman]

They changed the rules again Friday night. Got to SEC.gov to read about it. Market makers can still go naked short..

[Nighthawk]

Interesting that no-one's commented on the impact that the rescission of Rule 10a-1 might have had. Bring up a historic chart for the VIX. You'll note a huge spike in volatility following the rescission of this rule by the SEC who, last year, caved into the hedge funds and bought their argument that they could self-regulate and wouldn't engage in naked short selling unless exempted. Yeh, right.

If you want rational investors who are the backbone of American capitalism and are the folks who invest in the capital markets, to pull up stakes and go elsewhere, just continue to allow unchecked short-selling. Profit is great but when the rules allow the plundering of companies by speculators to the detriment and in this case, near collapse of a critical element of our capitalist culture, then it's gone a bit far, don't you think. Try refinancing your Home Equity Line of Credit to make your Escalade payment if you manage to allow a "few" short sellers to "kill" the major banks through unchecked short selling.

The real winners in this debacle will be the private equity sponsors who are going to capture capital from investors who are tired of making fundamental investments only to see themselves being screwed over by a bunch of kids with momentum indicators who begin to pile on by pushing the SELL button, knowing that they don't have to wait for an up-tick and knowing that the SEC enforcement of naked short selling has been rather loose.

[User 148980]

Nighthawk, I was wondering why so many people are blaming the fall of bank stock prices on speculators when it was clearly the bankers themslves.

[pcyhuang]

Your opening paragraph: "To the extent that the SEC has evidence that naked shorting is going on, then more power to 'em to try to put an end to it (but if so, why limit the new regs to only 17 stocks? Get rid of all of it!). I'm somewhat skeptical, however, that naked shorting is widespread and had much to do with the declines in the stocks of the 17 companies"

This just shows your negligence about the accuracy of your information and your total ignorance about the subject matter.

[lefty]

I'll just simplify all the above comments.
ALL shorting should be illeagle. A stock should be worth what it actually worth. I think I shall borrow a car and promise to sell it to someone.

[themicrokid]

The SEC should have long ago stopped all naked shorting.

Their continued allowance of the practice is criminal.

Those spreading false rumors leading to the demise of stocks, should be viewed as an act against the United States itself and therefore they should be tried for treason. Of course free speech should be allowed.

[Did U ThinkThe PonziSchemeWould Last?]

You only provided 23 of the logical choices. Neither "misguided" nor "right on" do not apply here. The correct choice would be "not applicable" AKA "doesn't matter" aka "more jawboning and useless posturing".

This only proves 2 things:

- If the fed feels the need to manipulate "free markets" then the problems are worse than most people know.

- The fed is a toothless old tiger which needs to be taken out back and shot. But not until justice comes looking for that "traitorous bastard", Greenspan.

[train wreck]

"the fact that not only have we never naked shorted -- our prime broker I'm sure wouldn't allow it"

This is extremely wrong. If the prime brokers do not allow it, that who exactly is creating the aggregate $8 Billion daily fails to deliver in the system today?

I ask Mr. Tilson to respond to this simple question before he makes such inaccurate and deceiving comments. Two types of trading scenarios will be described. How is Tilson's fund treated?

Trade I.

Hedge Fund XYZ enters an order to purchase $500,000 in stock in company ABC. By the third day that fund is expected to put up capital to support the payment for securities purchased. If after 3-days such capital is not provided the broker dealer will:

A.) Sell out the position as much necessary to cover the expenses including, if necessary, selling out additional positions to cover the fees.
B.) Contact the fund and provide them limited relief on payment.
C.) Contact the fund and notify them of the error and provide them indefinite time to make good on payment.

I believe by law the only answer acceptable is A.)

Trade II.

Hedge Fund XYX enters order to short $500,000 of securities in Company ABC. The hedge fund has either provided the locate or relies on the BD to do the locate. After 3-days the trade fails settlement because no shares have been borrowed to settle. The broker-dealer will:

A.) Go to the market and purchase shares under guaranteed delivery to cover the fail?
B.) Go into the market and attempt a buy-in (no guaranteed delivery) looking for available shares at the market price. If the market does not have shares available that will settle buy-in terminated.
C.) Let the trade fail indefinitely because an original locate was made so why bother to settle unless called upon by the receiving client.?

The only acceptable answer to parity Trade I response would be A.) In both cases the Broker Dealer would have committed to the contract executed. What Tilson would have you believe is that answers B & C are acceptable answers and they are not. No private investor or institution investing for proprietary accounts has the right to effectively use the market making exemption from settlement. It has been the abuse at this level that has allowed fraud and manipulation to take place.

So Whitney, are you immediately bought in under guaranteed delivery when the locate you provided failed to result in a borrowed stock and delivery or did somehow your prime broker keep the trade active and hold the failed trade liability? If not, you have engaged in Naked Shorting and I am sure that your traders are fully aware of a trade in which they have had a bad locate.

[TradeKat]

Tradestation has banned ALL shorting of stocks in the SEC order - even if shares are available. The SEC is clearly aiming to save the listed banks by effectively removing them from most downward pressure. These banks started this mess and now theyt are being shielded. You all should be outraged.

[fxtrader07]

Dear Mr Tilson,

you don't know anyone naked shorting stocks? hm, sure.
Those who did naked short would as likely tell you about it as you would tell us here, eh? Whom are you kidding?

And are you aware of the statement made by the SEC chairman Cox on March 4, 2008 where he described naked shorting as ' a serious problem especially for smaller companies'? He stated:

'Illegal naked short sellers don’t bother with that part. They sell shares of stock that they haven’t borrowed, and that they have no intention of borrowing. In some cases, they sell shares that don’t even exist.
Illegal naked short selling is an especially serious threat to smaller public companies, whose relatively thin market capitalizations can be more easily manipulated. And in the same way, it threatens the savings and investments of many retail investors in these smaller companies.
There are many legitimate reasons that a trade might fail to settle, but the extreme abuses that are reflected in securities being chronically listed on Reg SHO’s Threshold Security List for months and years at a time is ample evidence that there is also fraud in the market that needs to be arrested.
Periodically there are reports that following a legitimate purchase of 100% of the outstanding shares of a microcap company, millions of phantom shares continue to be traded by naked short sellers.'
source: investorprotectioncoal...

[fxtrader07]

a prime example for illegal naked shorting: btw: JOSB is a fine cloth retailer with 92%(!!) of its float shorted. Instittutional ownership is a whopping 147%(!!!).
Incidentally, the stock is a favourite short among hedge fund managers. I wold not be suprised to learn that Tilson and/or his buddies Ackman, Einhorn etc. are short the stock as well. But of course, not illegally naked short, right?