The Old Shell Game
I was at dinner last night, and a friend of mine asked me how long I thought that the abuses had been going on, and how large I thought the problem really was, and why nobody is doing anything about it.
First, as to the question of how long.
In 1999, the Depository Trust Corporation (DTC) bought the National Securities Clearing Corporation (NSCC) and created a new uber-entity – the current Depository Trust Clearing Corporation (DTCC) – entrusted with not only dematerializing every paper share and holding them all, but also now with clearing the trades and lending shares out to make the system run more efficiently. I believe that the real fail to deliver problem began in earnest then, when you had the same accounting firm doing both companies’ books, and you had like minds all thinking alike with the same imperative: how to make the maximum amount of money from the clearing and settlement and holding process. I believe that the real abuse began then, and has continued in an ever more ominous and dangerous manner, to this day.
The NSCC’s stock borrow program was set up to handle short term failure to delivers – like a day or two over the line. No problem there. But I believe that the system, and the avarice that is a natural lubricant for it, saw a way to create more trades, more commissions, more interest from the borrow, and more “liquidity.” Just abuse the short term system and convert it into a long term stock printing system – more commissions for the owners of the DTCC and NSCC (the brokerages) due to more shares available to trade every day, more fees from the borrow program, more fees from hedge funds who require a greater number of shares than the company ever authorized in order to achieve their goals of reducing prices to the point where their shorts were in the money. In short, everyone benefited from the practice financially, except of course the companies and their shareholders – but they are a fragmented lot, and the system, like most systems, is in place to perpetuate its own power and profitability, not be fair to the pawns in the game.
As to how large a problem it is, that is a little harder to pin down.
Overstock.com is one of my favorite cases, not just because I believe that Dr. Byrne is a man of genuine integrity and courage, but also because the timing of their manipulation is such that it provides us with a handy test case. OSTK showed up on the Reg SHO list on January 27. If SHO was working, it would have been off within 13 days. It is still on the list to this day. That tells us that any facile explanations involving prior grandfathered fails keeping the company on the list don’t apply. It also tells us that the rules are not being enforced, and that the system continues to fail us as investors, and as owners of companies we invest in.
The truly staggering part about all of this is the studied lack of any official response from the SEC. They are strangely silent on the matter. Not a peep out of them.
Now, where I come from, I would think that if the regulators have a pretty basic charter – keep the markets fair – and if they clearly aren’t doing so, well, that there would be a lynching at some point. Apparently that’s not the case with the SEC. They have allowed flagrant abuse of the system, as evidenced in my personal favorite case of the moment, the Compudyne matter, where a New York hedge fund sold over a third of the float of that company short in 975 separate transactions, EVERY ONE A FAIL TO DELIVER, and yet not one was flagged or stopped or caught by the system. Or another fun one, from Professor Leslie Boni’s paper, wherein she reviewed the trading of one market maker, where over 68,000 failed trades were put through for this one group, and a whopping total of 86 were bought in as the rules mandate. The rest were allowed to fail. And nobody did anything.
Now, I don’t know about you, but if I was allowed to break the rules in any business for profit 68,000 times, and only got penalized 86 times, I’d be thinking that I had a pretty good gig going.
Why are these noteworthy? Well, in the Compudyne case, because it is the NASD bringing the charges, not the SEC. The SEC is silent. And because the Boni paper was written while she was doing research for the SEC at the SEC.
So how big is the problem? As discussed many times before, the DTCC won’t tell us, or the companies. The SEC isn’t asking them (supposedly), although they haven’t really articulated why they aren’t asking them. And the exchanges aren’t telling, supposedly because the data is the DTCC’s and they aren’t allowed to disclose it.
So what it adds up to is a conspiracy of silence on what I believe will turn out to be the single biggest scandal to hit the regulatory environment as well as Wall Street in a century. I believe that the problem is pervasive, endemic to the system, and so widespread that the SEC is afraid to pull back the system and show the public what has occurred on their watch. I think they know it would horrify us, and drive capital out of the markets, and BK many of Wall Street’s finest. Now, all that might seem nutty at first blush, but in parting, consider this:
Not one person, not the SEC, nor the DTCC, nor the exchanges, is willing to just show us what the level of the failures are.
And that is the single most frightening aspect of it all. The silence is deafening.