Documents Show How Goldman et al Engaged in 'Naked Short Selling'
rollingstone.com
rollingstone.com
Fortunately the solution is quite simple. Force short sellers to make the shares available instantly at the time of the short. They could be held in escrow by the exchange until settlement either way. Go go gadget SEC?
How? It only does so if one sets out to do it on purpose, and in that case there is no difference between selling something that own, or that you don't (yet) own.
Let's say I sell grain to you for 300 USD per ton, to be delivered in Fall 2012. How does that distort the market? Alternatively, how is this example different from naked selling? Or isn't it, and do you think that this sort of insurances should be prohibited too?
"In many contexts I think most people would consider it fraudulent to sell something before you've bought it."
I'm not sure. There are many retailers who only order something from their wholesaler or manufacturer after you've bought it from them. Why would a buyer be concerned with when or how a seller gets his merchandise? It only becomes a problem after failing to deliver the goods, and when no adequate compensation for such a failure can be given (i.e., a seller going bankrupt because of a naked sale gone wrong). Something that could be controlled, regulated or mitigated in many ways that are much less intrusive than forbidding 'naked shorts'.
From the article: "In other words, 107% of all Overstock shares available for trade were short – a physical impossibility, unless someone was somehow creating artificial supply in the stock."
That is to say, there were more Overstock shares in the market than actually existed, because they were borrowed from thin air.
With a retailer, the merchandise will get delivered, and then the buyers will have it forever. With 'naked shorting', the merchandise is created from nowhere, lent out, sold, rebought, returned, and then disappeared. The shares never actually exist. But they affect the market as if they do exist - e.g. more shares existing in a company means every share is less valuable, so by magicking these shares into existence the price is equally magically dropped, which helps makes the shorting auto-succeed. It is straight up cheating.
Imagine a grain holding company lends you some paper 'shares' that are stand-ins for X amount of grain. It produces many of these shares, flooding the market with 'grain', and as a result the price falls. At this point their lenders buy up the grain from grain farmers at these lower prices, thus making a profit, and then return the grain to the company who then hands it out to the people who bought the shares. In this way, the grain farmers lose money because their product is devalued, while the company and its investors make money. This is the only mechanic at play: money flowing from the people who create value into the pockets of the market manipulators. Oh, and this 'grain holding company'? They never had any grain to begin with. All they had was the know-how and connections to lie and get away with it.
This is a situation that would be EXTREMELY unusual because it's very, very dangerous for the short sellers. I could recall all my lent out shares and unless I sell one of the shares I own there is no way for the short sellers to deliver so the price will spike into the stratosphere due to a short squeeze.
The fact that short sellers were willing to short stock despite the massive short interest (which is a publicly available number) means the market as a whole believed that OSTK was wildly overpriced, which in hindsight it was.
Why does it matter that there are more shares being traded than that actually exist? It isn't about the actual trades, it's a simple contractual thing - one party promises something, the other agrees to pay for it, and as long as both end up satisfied, that's it. There is no 'merchandise being created from nothing', it's just one party promising to do something, that's it.
"e.g. more shares existing in a company means every share is less valuable"
This doesn't make sense - there are no shares created. There is a party promising to deliver shares, that's completely different.
There are lots of "don't have it yet" processes. Consider the typical loan. The borrower typically doesn't have the money at the time that the loan is made.
Anyway, the futures market has functioned for centuries with people buying and selling what they don't own, and the big institutional buyers and sellers commonly use futures prices as their benchmark prices. It looks like the smart money isn't too concerned about negative effects on price discovery.
Also, let's not confuse playing by the clearly established rules of the market with "fraud". Moral objection is no excuse for equivocation.
However, with naked short selling it's a different story. When you're short selling something that you don't own you're in effect making it look like the supply is bigger than it actually is. This distorts the price discovery mechanism.
So what's the objection? If you buy, hold, and sell, you want prices to be overall lower. Selling low isn't bad if it means you were also buying low. In short, as Warren Buffet likes to point out, low prices are good for investors.
They're not pretending to follow the rules of the market, they are actually following the rules of the market. Having actual posession of the item at the precise moment of sale is not a rule of the market in question. Lay investors still get their shares delivered, so I have no idea what you're worrying about.
The fact that no one was willing to do that to OSTK stock tells you how shitty the company is and how overvalued the stock was.
The risk of massive short sales are not to the naked short-sellers. Thus the market does not work as an automatic way system taking this into account.
Moreover, the hypothetical that the market prices in bad behavior is not a justification for bad behavior.
Can you reference me instances of such penalities being applied?
I searched for instance and instead found this:
http://www.billcara.com/archives/2006/09/a_failure_to_de.htm...
(technically the law is more nuanced, of course - there is a whole field in law dealing with the subtleties of this, but this is what it comes down to, and it's the same whether it's for stock or grain or a wedding dress).
Thousands of systems would need to change at brokers, banks, clearing firms, trade processing firms etc including mainframes running Cobol software that was written in the 70's at quasi-governmental firms like the DTC. Documentation for these systems is mainly non-existent or incorrect.
What happens now is that at the end of the day registered brokers net out all trades done by them and send files which include trade details and net trades to the DTC. On T+1, you and T+2 you figure out what would fail and why. For example, let's say Zuckerberg sells some FB. Based on FB's corporate bylaws his shares change class when he sells them so they have fewer voting rights. So when he sells them the system at his brokerage barfs because the cusip does not match the publicly traded share cusip which then leads to a cascade of fails down the line because whoever he sold it to may have sold it to someone else.
You can't just automate rules like change the class of stock if Zuck sells it because the rules are different for every company and the rules change as the board adopts new bylaws and companies change their capital structure and the systems can't change that quickly because they have to be super, super reliable. If the DTC's clearing systems go down, the US economy has a BIG PROBLEM.
About 1% of trades result in a potential failure to deliver on T+1. The vast majority of these are resolved between T+1 and T+3 so that the trade clears. Some don't. It could be something like an investor who still holds paper certificates delivering them to the broker but the courier was late etc. Resolving these fails often involves the company's registrar in addition to financial systems, for example FB's registrar would have to change the class of stock if Zuck sold his stock.
Company registrar's aren't exactly paragons of customer service. Companies generally want to hire the cheapest firm because to them it's just an added arcane expense. The registrar provides service to a back office guy at a broker, and he back office guy really doesn't have a channel to complain to the company's CFO. So the registrar generally has no incentive to provide good service and the company has no reason to fire them and change them because as far as the company is concerned it's just a expense they want to minimize and changing registrars is a huge headache.
A failure to deliver does not mean the trade is somehow cancelled. It means that either the broker or the seller needs to find stock that is good to deliver. If you go out to T+10 and there isn't a VERY GOOD DOCUMENTED reason for the fail, like a tardy registrar, the buying broker and DTC will demand deliver and buy you in if necessary, ie buy the stock in the open market and deduct your account for the cost including a generous commission for themselves. So a fail is generally a very bad thing that a seller and his broker really, really want to avoid.
Pre-2008 the rules around short selling were that if a stock was widely available for borrow, you could short it without checking. Widely available means many different owners willing to lend the stock at reasonable prices.
In 2008 in a totally made up frenzy the, same SEC which failed to stop Madoff decided to impose a new rule stating that you needed affirmative determination of a borrow before you shorted a stock. The rule makes no sense because if there were to be an event that would cause a widely available stock to suddenly become not available, you would still have fails. Remember settlement is T+3, so you would check the accounts of the people willing to lend the stock and see that they still had the stock there without realizing that it would be gone in 3 days.
The SEC subpoenaed pretty much everyone because they decided that of course the market and particularly financial stocks were going down due to naked shorting as opposed to uh'm the economy and found essentially no evidence of manipulative short selling. They brought one case against a tiny broker who made a minor paperwork error essentially unrelated to affirmative borrow other than a truly tortured link link between the two made in the SEC's press release.
Short selling is a GOOD THING. Remember in any market, the people who have the biggest influence on prices are the ones who have amassed the most capital by consistently being right. When someone who has been consistently right decides to sell a stock short, s/he is providing a very valuable service to the economy by signaling that what she's shorting is overpriced. Remember shorting is very risky. The price of a stock has no upper limit but can only go as low as 0. So when you short you can make at most the current price of the stock but lose an infinite amount. Also remember that when you short, you also have to buy the stock back at some point. There are those pesky people you borrowed the stock from who want you to return it. So on average you are selling the stock when it's overpriced and buying it back when it's underpriced and the price is under pressure. The overall mechanism creates a very valuable self correction mechanism that is absolutely essential for a healthy market. If the SEC really cared about the market's health as opposed to PR, they would be working to make shorting easier because it prevents bubbles.
Remember that the total amount of short interest in a stock is a publicly available number. If the stock of a company you are an insider of is heavily shorted and you think it's cheap and you actually believe it as opposed to want to create a huge hullabaloo, you can go out and buy it, make noise about the fact that you are buying it. If the stock is genuinely cheap or even fairly priced, you will generally create a short squeeze where shorts are forced to buy back quickly as the stock shoots up in their face. OSTK insiders did not do that.
I don't actually know of a single instance where an insider or corporate inside has complained about a short seller shorting their stock and pushing the price down where there actually weren't genuine problems with the company. Remember it often takes 2-3 years for the whole story to come out and by then the media may not want to acknowledge that they breathlessly repeated every bit of tripe the CEO said about the evil, faceless short sellers. Usually a CEO complaining or a company filing a lawsuit against a short seller is a very high probability sign that the company is in genuine trouble because otherwise you would see insiders backing up the truck to buy the stock.
I find it truly amazing that the press and from the comments even the supposedly informed set at Hacker News would get worked up about this when it's about OSTK, Overstock.com. They sued people for shorting the stock and driving the price down for 60 dollars a share!! by making negative statements about the company that weren't true. With the benefit of hindsight it's clear that pretty much everything negative publicly said about OSTK was not just true but probably too optimistic, and the management has been lying which is felony under US law. Yet the SEC refuses to prosecute the management which is who is truly responsible for fleecing gullible retail investors.
It's truly astounding that OSTK is now choosing to go after GS based on snippets of emails etc which sound bad if you don't understand financial terminology and also don't have context but really aren't anything particularly bad, unless of course you let Tabibi self-aggrandize himself by claiming he understands stuff he has absolutely no clue about.
More damning is an email from a Goldman, Sachs hedge fund client,
who remarked that when wanting to “short an impossible name and
fully expecting not to receive it” he would then be “shocked to
learn that [Goldman’s representative] could get it for us.”
Basically, you're increasing the amount of good for sale, without the corresponding purchases that would normally balance that out. It's the converse situation of buying things even when you don't have the money (not even in the form of credit or loans), and distorts the market in corresponding ways. The market is robust to a certain amount of shenanigans like this, but when a player the size of GS is doing it willy-nilly, the distortions can become measurable.
According to econ 101, naked-shorting is observationally equivalent to a sudden inflation of supply, which should drive the price down. Lowering the price benefits those in a short position, at the cost of people who are taking a long position, like value investors, or the companies themselves. If you have weight to naked-short enough volume that it actually effects the market, you would in theory be pushing the stock market down and pocketing the difference.
Again, I'm not an expert and this is a pretty naive analysis. I am willing to be corrected. Eventually you have to cover your short, which in theory should un-do all the market effects you've done, but my gut says that in practice the sudden drop has lasting damage to intangibles like "investor confidence" and "market volatility."
The lawsuit between Overstock and the banks concerned a phenomenon called
naked short-selling, a kind of high-finance counterfeiting that, especially
prior to the introduction of new regulations in 2008, short-sellers could
use to artificially depress the value of the stocks they’ve bet against.There is a story here, but this is not the author who's going to write it.
I mean...where does the money to cover the customer's profit on a naked short come from?
Evidently there is some amount of time between when a stock transaction is booked and when it clears - like a purchase made with a check. They were essentially writing bad checks by selling stock they didn't own. If the price of the stock went down, they would actually go out and buy the stock at the new lower price. If the stock went up they would say, sorry that stock transaction "failed" - darnedest thing, just happens sometimes.
"Instead, he preferred to just sell stock he didn’t actually possess. That is what is meant by, “We want to fail them.” Trafaglia was talking about creating “fails” or “failed trades,” which is what happens when you don’t actually locate and borrow the stock within the time the law allows for trades to be settled."
Say you think XYZ, currently priced at $100 is going to go down in price. You tell your broker (GS in this case) to short 1 share in the market. GS sells XYZ (someone else buys it) and you get $100 in your account while the quantity of XYZ shows up as -1. Later, the price does drop to $90. You tell GS to buy 1 share, and you pay $90 for that share.
You now have $10 in your account ($100-$90) and the quantity of XYZ in your account it zero (-1 +1).
Someone else in the market lost this money, you gained it. GS was supposed to have borrowed this 1 share from someone, but they didn't. In other words, for a short time, this 1 share was created out of this air.
If there was a system to make sure that every single transaction was backed by an actual share, then this would not have been possible. However, transactions are not actually reconciled on a real-time basis.
Someone with more knowledge of the back office will have to explain how such naked shorts can exist in books for longer than 3 days (perhaps GS was rolling over these shorts?)
I sell short at $100, GS gives me that $100. If there's no share behind that to sell, then they just gave me that $100 out of their own pocket, right?
So then the stock drops to $90 and I cover my short by sending GS $90. There's still no real share to deal with.
So GS gave me $100, had no source for that money other than their pockets, and I gave them back $90. They're down $10 of their own money.
This can't be how it works or they wouldn't do it, and if they did, no one would be complaining.
So how does it actually work?
Normal shorting is when you "borrow" a share from someone else with the promise of giving it back at a given date. You sell it and pocket the current price, then try and buy back the share in the future at a lower price, pocketing the difference.
In reality, money never changes hands during a short (other than the cost of setting up the short). The short is only due at the end of the borrowing period (or before if a margin call happens).
So in the case of a naked short, it's more of a bet on GS part. They don't located a share to "lend" you, they just say "ok, pay us a few dollars and you have a short". If the stock goes down, GS gives you the difference, if it goes up, you pay up.
It's basically a bet and GS is the counterparty.
When you instruct GS to sell the share for you, GS actually went to the open market and just sell the share.
They are supposed to deliver the share at some time later, when they have found the share to borrow. However, they can do nothing and wait for the deadline to come. If the price drops, they will buy a share to deliver the previous sell order, and make a new sell order at the same price to "extend" the delivery deadline.
The SEC website says disclosing this info would put firms like GS at a competitive disadvantage.
But someone has to know which sales cleared and which did not.
How can we accurately set a market price for something based on historical sales data that may in part be false (i.e. sales that were never cleared)?
And really, getting your blood boiling is just about all Taibbi is good for.
Last week, in response to an Overstock.com
motion to unseal certain documents, the
banks' lawyers, apparently accidentally,
filed an unredacted version of Overstock's
motion as an exhibit in their declaration
of opposition to that motion. In doing so,
they inadvertently entered into the public
record a sort of greatest-hits selection of
the very material they've been fighting for
years to keep sealed.
Last week, the banks' lawyers filed an
unredacted version of Overstock's motion
as an exhibit in their declaration of
opposition to that motion.
The information about this comes from internal Goldman emails produced during discovery which admit to the practice. Emails that Goldman has fought in court to prevent the release of, only to have one of their own lawyers screw up by filing something not under seal.
EDIT: If you want to quote the actual emails, I've added most of the quotes from them below:
"Fuck the compliance area – procedures, schmecedures," chirps Peter Melz, former president of Merrill Lynch Professional Clearing Corp. (a.k.a. Merrill Pro), when a subordinate worries about the company failing to comply with the rules governing short sales.
"He should be someone we can work with, especially if he sees that cooperation results in resources, both data and funding," the lobbyist writes, "while resistance results in isolation."
“We are NOT borrowing negatives… I have made that clear from the beginning. Why would we want to borrow them? We want to fail them.”
“Two months ago 107% of the floating was short!”
“We have to be careful not to link locates to fails [because] we have told the regulators we can’t,” one executive is quoted as saying, in the document.
Is the issue whether and how GS makes money from the practice of naked short selling? Maybe the issue is that feeding the market with info about short sales that are never actually cleared (but which the market assumes will be cleared), can destroy the value of a company's stock.
Obviously if you can sell something without ever having to own or deliver it (is that really a sale?), you can do a lot of selling; and you can exert considerable influence on the market for a stock.
Maybe what happened here is a company, Overstock, believes they got screwed by naked short selling.
I need to read the motion to get a better idea of what happened.