An Ugly State Of The Union
First, a recap. The SEC initiated Regulation SHO in January of 2005, requiring that any stock that had more than 0.5% of its outstanding shares AND 10,000 shares Failed To Deliver (FTD) would go on a list - the REG SHO list. Settlement failures have been against the rules (specifically, rule 17(a)) since 1934. As part of Reg SHO, the SEC "grandfathered" all past settlement failures. The DTCC owns the DTC and the NSCC, and is a monopoly assigned with clearing and settling all public equity trades in the U.S. That monopoly is owned by the brokers - the "participants". It is a private corporation organized under NY banking laws, and is a Self Regulatory Organization, meaning that it is supposed to police itself, and uphold all securities laws. One could easily argue that it is an alter-ego for the Wall Street brokerage community, as is the NYSE and the NASDAQ - that is the position I take in my scribblings.
In the interest of capturing my thinking on the nature and scope of the problem for posterity, I thought I would do a September State Of The Union address, and recap my understanding of the current situation. So here it is, in no particular order:
1) Reg SHO is a failure.
It fails to protect investors, and fails to live up to the most basic requirements of a reasonable measure. The reason it is a failure is fundamental to the flaw in the thinking that created it, namely that some settlement failures are acceptable.
If one views the SEC's mandate, it is theoretically to protect investors, thus justifying a restored faith in the system following the Crash of '29 and subsequent financial chaos. One of linchpins of that restored faith was that trades would clear and settle in a timely manner, eliminating the potential for abusive short selling that typified that period. The thinking was that if one established a reasonable period for clearing (the processing of the order and the buy/sell transaction) and settling (the physical delivery of the shares and the funds, e.g. the conclusion thereof) that one could eliminate naked short selling, wherein a stock was sold into the ground with a stream of sells, and delivery was never made, or was delayed beyond a reasonable period. Back with 1934 technology, reasonable was five business days following the transaction day - T + 5, later ammended to T + 3 in the 80's.
That was great, and settlement failures were pretty academic - if there was no delivery of shares, then no payment was made, and the transaction was void - a broken trade. Seems reasonable - if you didn't deliver the goods, you didn't get any money, and no commissions were paid to either broker (buyer or seller). That worked well. Everyone was motivated to make the trades settle.
Because otherwise nobody got paid. And Wall Street loves to get paid.
There were no extended settlement failures - rule 17(a) required timely settlement, and everyone's pay was based on timely conclusion of the trade.
Before we continue, understand that 17(a) still requires timely settlement of trades (the exact wording is "the prompt and accurate clearing and settlement of securities transactions including the transfer of record ownership"), and does not authorize anyone, not the DTCC, nor the SEC, to just waive the requirement that trades settle promptly and reasonably (the part where delivery is achieved and ownership is transferred) - thus, the notion of grandfathering hundreds of millions of past settlement failures (that SHO pronounced with a stroke of the pen) violates one of their primary mandates - prompt settlement of trades. If it ever faces a legal challenge, I believe it would be struck down as unlawful. I know it, the SEC knows it, and the participants know it. The only reason nobody has sued is because there's no money in it. But make no mistake, it is unlawful.
Now, the SEC will likely argue that the NSCC has Carte Blanche via the NSCC's Addendum C (which was passed by the NSCC to enable the now infamous Stock Borrow Program) and its allowance of "reasonable" settlement in light of "legitimate" failures to deliver, but I would simply direct everyone to consider the idea of "reasonable" settlement.
In a Six Sigma world of nanosecond technology.
Professor Boni's research paper concluded that the average age of a fail was 56 days. Does anyone think that 56 days would survive the reasonableness test in 2005? It would have failed 71 years ago, and it would fail today - hence Reg SHO is a farce and a failure, and I believe illegal in its grandfathering provision. Now the DTCC will fall back on the NSCC's self-penned Addendum C, which allows for settlement failures for "Legitimate" reasons - but does anyone believe that hundreds of millions of FTDs aged for months are "Legitimate", much less reasonable? The bond market clears and settles in T + 15 seconds - what would a legitimate failure look like in equities? A couple of hours? Maybe a day or two? Definitely not 56 days. Thus, the Addendum C argument is a ruse, and fails any reasonable interpretation. The system is being gamed. And the DTCC and SEC are facilitating it, and using a flawed argument to justify it.
2) Fast forward to the modern era, specifically to the 90's, when Congress agreed that it was a good idea to dematerialize paper stock certificates, and to let the DTC act as a bank, where the certificates would be kept, and one electronic book entry (tick) would be created for each legitimate share. Great in theory. No more paper running around the Street, and increased efficiency. The problem is that the DTCC, the parent of the NSCC and the DTC, decided that it was going to separate out clearing and settling, and no longer require that trades settle in order for everyone to get paid.
You read that right. On Wall Street, signing a contract to attempt to deliver stock at some point in the future now gets everyone paid. Imagine if selling a house worked like that - your real estate broker would get paid and your account debited at the point that he agreed to try to get you a house matching certain specifications. Or imagine a car salesman getting paid the second you signed the agreement, and you got an IOU instead of a car - he'll try to find you one just as soon as he can, or whenever he gets a chance - maybe his acquisition cost will go down if he waits long enough...
Does anyone else see how badly broken this is?
By breaking out clearing and settling as two separate items, the DTCC and the participants that own it have engaged in a nice little rhetorical fraud. They can "clear" the trade the same day it is entered, and the DTCC, the brokers, even the SEC all get paid, and the settlement portion is left as an afterthought that is not really a requisite for anything.
That creates institutionalized fraud, wherein your money is taken, you receive a brokerage statement indicating that you received "shares", but in many cases what you got was an IOU, which has no voting rights, and no ETA as to when it will be converted into real shares - IF EVER!!!
One of the neat tricks the system set up was where the NSCC became the contra party in both sides of the trade, meaning that if the Stock Borrow Program was used in a settlement failure situation, there was no direct connection between the buyer and the seller. By intermediating the exchange, the NSCC now could create plausible deniability if shares didn't show up - it could "borrow" shares held in an anonymous pool, which would be credited to the buyer's broker's account, which would then go right back into the anonymous pool the next day - creating a virtually unlimited stock creation scheme, unlicensed and unauthorized by anyone (again, the DTCC will argue that addendum C gave them that right, to which I would direct them to the reasonable terminology, and the open-ended failures that are the reality - certainly more than 1934's standards, thus unreasonable given current technology).
So we have a de facto stock manufacturing scheme, wherein the number of electronic book entries has nothing to do with the actual number of shares in the DTC vaults (that's how it was originally intended; 1 electronic share for 1 paper share) due to the Borrow Program's abuse by its participant owners - a function of the DTCC becoming a monopoly, with nobody to ensure that anything about the scheme was rational or reasonable - certainly not its participant owners, who now get paid without delivering anything, and for which failure there is no apparent deterrent or penalty. And it is all presided over by the SEC, who relies on the conceit that the brokers and the DTCC will act in good faith, in the shareholders' best interests, on the honor system.
Absolute power corrupts. As always. And yet the SEC and the DTCC act as though this time in history is different than all other similar times in history. Why would any reasonable person believe that?
3) The worst is yet to come, though. If I am correct, the ex-clearing problem that was created when the DTCC decoupled clearing from settling is now wildly out of control, and is likely at least 5 times as great, if not 10 times or more as great, as the REG SHO Fails.
Here's how the ex-clearing shell game works: The DTCC has a system wherein they will clear the exchange of money for the two parties, but then let the two parties arrange for settlement off-line, between the two of them. You read that right. Again, everyone gets paid, but now the DTCC is out of the loop, as it is just between the two brokers as to when the actual goods will be delivered - if ever.
Now, does everyone get this? The brokers that own the DTCC get to decide when and if the shares get delivered, and they tell nobody at the DTCC - it isn't the DTCC's business what two companies do, after all - that's their business, and presumably they are obeying the rules and delivering promptly.
Am I the only one that understands that this creates a system where the brokers can literally create money at will, and as long as nobody breaks ranks, nobody ever has to deliver anything, ever? Does anyone see any difference between this and just printing as many shares of stock as a broker feels like? No cost of goods sold, and no real barriers as to how many shares can be sold into the market, as long as the den of thieves keeps its second set of books away from the prying eyes of the DTCC - who being owned by them, isn't particularly interested in upsetting the apple cart anyway.
This whole out-of-control scheme has now gotten to the point where I believe that the entire market system is dangerously jeopardized, and is in fact now constructed to ensure that companies which have been abusively shorted using Stock Borrow and ex-clearing FTDs stay depressed in price, or better yet, go out of business. Besides eliminating any effective requirement for delivery, one of the other nice things the DTCC came up with was to allow the sellers who sold the FTDs to have access to the cash they generated due to the FTD sale, over and above whatever the current mark to market price is today.
What that means is that if Short Seller A sold a million shares of NFI naked and FTD'd them at $60 or so, and today's price is $35, Short Seller A gets to use and in fact keep the delta between $35 and $60 (with some remaining above the $35 for collateralization requirements). Call it a cool $20 million assuming that $5 was kept as a collateralization premium. Now, in what other world does the seller get the proceeds from a sale that he never delivered the product on, and which he likely never will?
But it gets better. If Short Seller A gets into bad trouble, and has 20 companies he's done this to, and if he goes belly up, guess what? The DTCC has the financial obligation to make good on buying and delivering the shares, along with the brokers that sold the FTDs, and which are also owners of the DTCC. Does everyone see how it is in the best interests of everyone in the system EXCEPT the company and the shareholders to ensure that once a company is under an attack that results in FTDs significant enough for the company to show up on the SHO list, that it stay chronically depressed, for the duration? How can one achieve that? Why, keep selling more FTD's, and take them ex-clearing!
Folks, I believe that this is a centi-billion dollar problem now. The math bears that out. The DTCC says that the Stock Borrow Program satisfies 18% of the daily FTDs. If 82% of the daily FTDs are not handled by the Borrow Program, then the obvious answer to the question of where they all go is simple - they go ex-clearing. The end result is that now the brokers have significant skin in the game to ensure that the companies' share prices stay low in perpetuity.
That is where I believe that the fraud is the worst. The brokers no longer have to deliver squat, thanks to rules that their SRO, the DTCC, passed, so their interests are no longer as the custodians of the shareholders' interests. Their interests are in fact the diametric opposite. They are alligned with their biggest customers - the short selling hedge funds. How convenient.
So that is where I have arrived, after working this issue for 6 months or so (NCANS was created in February) - we have the SEC knowingly violating its mandate to protect investors and ensure that trades are settled in a timely and reasonable manner, we have the DTCC and the participants removing the delivery obstacle to separating investors from their money, and we have a system that is now organized to perpetuate a systemic fraud that is large enough to where it likely exceeds the DTCC and the participants' NAV and ability to buy all the shares it has created - leaving it with the only alternative it can use - destroy most if not all of the companies that have been the most brutalized. Either that, or face financial Armageddon.
You can't be forced to buy millions of shares if the company is out of business, or is de-listed.
Does everyone completely understand just how far this has gone?
Feel free to send this to your elected representatives, and your state securities representatives. Forget about the SEC - they are clearly part of the problem, IMO.