Thursday, March 24, 2005

The Old Shell Game

I’ve written a lot lately about the shenanigans that are part and parcel of our equity markets, and how the current ghost in the machine appears uniquely predisposed to favoring the companies that derive their income from handing our money. I’ve speculated about how the Depository Trust Clearing Corporation (DTCC) abuses the public trust in order to effectively counterfeit shares of publicly traded companies, and how our regulators appear happy to stand by doing absolutely nothing while the American public gets fleeced.

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. 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.


Blogger teachericjp said...

In a way i hope you're right, but at the same time, i hope you're not. If the problem is so huge as to cause a huge hiccup in the markets, it might be something that people will want to solve discretely. I hope Senator Bennett knows his stuff and probes deep enough to get to the core of the problem. I'm anticipating their next meeting, but it seems like their next meeting is at some indefinite time in the future. Meanwhile companies are being flagrantly manipulated right out in the open and the referees are blind.

10:38 PM  
Blogger smokyjoe said...

Before it is all over, I believe the real naked shorting prob began w/ Jim Kramer taking down msft on cnbc & Rocker shorting behind the ad. WCOM as well. I believe the crash of 00 was extended 150% by NSS. The doors to accomplish were opened by greenspan's bail out of LTCap.

12:47 PM  
Blogger smokyjoe said...

The post 911 recovery is prob in danger if totally exposed, 911 would never have been as effective a financial tool if not for greenspans abuse of office. I guess you can see I'm not a fan of his.

12:50 PM  
Blogger searchlight05 said...

If the masses advised the Bush Administration of their opposition to the Bush plans for Social Security reform due to the silence and inaction of the SEC on this problem, perhaps Karl Rove would get right on it.

6:58 AM  
Blogger Alan said...

Good article in today's NY Times on the subject of the phenomenal growth of hedge funds.

There will be an even more phenomenal meltdown when somebody finally takes action to stop the abuses.

9:49 PM  
Blogger dune165 said...

An other aspect I do not hear abput is: total NFI legal shares= 27.5 millions; total virtual shares= 8.5 millions, i.e. 30%.
Question is are my NFI shares real, i.o.w. can I use them to attemd the Annual Meeting with voting rights, or they are only electronic shares created by the DTCC?
2. Should the regulators start again from day 1 with a stroke of sponge, and my shares are partley or all virtual, what will happen, do I see my shares halfd, perhaps even totally disaapear, since they are all virtual shares.

6:06 AM  
Blogger particleswaves said...

Bob: Great write and read. I copied and sent it again to Thompson along with an inquiry as to his intentions (or lack of same) to respond.

Just for additional giggles and grins, thought I'd copy you the following letter I sent to Donaldson on Feb 23.

Dear Mr. Donaldson:

I am simply one of a growing number of "small fish" investors outraged at the SEC's lack of meaningful action against those who are allowed to naked short small companies out of existence.

The truth is out (I trust you saw the Washington Post earlier this month) and outrage is growing. There are literally thousands of average Americans who are now aware of the SEC's complicity in the sordid tale of the naked shorts. We know how much money the DTC "earns" by facilitating this rape of the small investor; moreover we know the SEC gets a "commission" on every entry. We small fish are becoming more organized and more vocal by the hour and will not rest until the pond is free from scum.

The "grandfather" clause in Regulation SHO that largely legitimizes criminal counterfeiting clearly tells us who you are in bed with and whom you have chosen to protect. Additionally, enforcement of any provision of SHO is predictably lacking to date and unless the SEC publicly corrects its posture the resultant bad press will bury you. In my view, it would be better to bite the bullet now, admit past errors and clean up the mess yourself. Arrogance of power and Band-Aid reform is no longer acceptable.

I've read comments by the SEC’s Annette Nazareth that are unbelievably supportive of the obvious collusion between the DTC, market markers, hedge funds and certain brokers; comments that advance the rationalization that this criminal activity is somehow necessary and even good for the overall market. The fact Ms. Nazareth is married to Roger W. Ferguson, Jr., Vice Chair of the Federal Reserve System, gives me additional pause re her overall agenda.

I of course realize that you inherited this can of worms so please do not consider this a personal attack. Nonetheless it appears you personally have a tough decision to make. Whose side are you really on and what will history say about your stewardship? Mr. Donaldson, one high-profile man with a will for truth and real reform can make a difference here. Are you that man?

Dennis Smith
San Diego

"Bob"...I don't have many hero's other than musicians, but you are right in there. Thanks for all you are doing for all of us.

Incidentaly, and probably needless to say, I never received a reply to the above.

Best Regards,

ds (particleswaves)

6:36 PM  

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