Subject: Overview of Clearance and Settlement system
You have requested an overview of how the clearance and settlement system deals with the large amount of stock that is not being delivered in the U.S. and elsewhere. All of the following are detailed in the enforcement actions I enclose. While the cases we have handled have similar evidence, I cannot discuss those (as they are subject to a confidentiality order that prohibits disclosure to people outside the lawyers and clients in the case).
Let’s understand what occurs based on the enclosed:
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Market Manipulation and Directors Fiduciary Duty of Care
Market manipulation of emerging or small cap companies is pervaasive on Wall Street and according to the SEC has increased over 37% in the last decade. The nature and scope of market manipulation schemes is limited only by the creativity and audacity of their perpetrators. While the substance and mechanics of market manipulation schemes may differ, the objective is the same – to inject false information into the marketplace that artificially affects the price of the target companies securities by “interfering with the natural interplay of the forces of supply and demand.” The proliferation of market manipulation scshemes has created challenging risk-management and best practice issues for the directors of targeted companies, which require directors to continuously assess the nature and scope of their fiduciary duty of care.
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Short Selling in Canada: Regulations are Weak and a New Path Forward is Needed to Reduce Systemic Risk
Based on our research, it is clear that IIROC’s largely non-interventionist approach and its focus on maintaining liquidity have made Canadian companies attractive targets for short campaigns. From 2015 to 2018 there was an increase in the number of short campaigns in Canada, while generally in other jurisdictions there was a decrease. Additionally, the number of short campaigns in Canada is utterly disproportionate to the size of our capital markets when compared to the United States, the European Union and Australia (as examples). The reason for this seems clear: short selling regulations in Canada are out of step with regulations in those other jurisdictions – see Schedule A attached hereto. As a result of inherent weaknesses in the Canadian short sale regulatory regime, short sellers may well be attracted to the Canadian capital markets.
PDF (164 Pages): Paper Analysis of the Short Selling Landscape of Canada
ABSTRACT: Pseudonymous attacks on public companies are followed by stock price declines and sharp
reversals. These patterns are likely driven by manipulative stock options trading by
pseudonymous authors. Among 1,720 pseudonymous attacks on mid- and large-cap rms
from 2010-2017, I identify over $20.1 billion of mispricing. Reputation theory suggests these
reversals persist because pseudonymity allows manipulators to switch identities without ac-
countability. Stylometric analysis shows pseudonymous authors exploit the perception that
they are trustworthy, only to switch identities after losing credibility with the market.
PDF (81 Pages): Paper Mitts Short and Distort
The Creation of Counterfeit Shares — There are a variety of names that the securities industry has dreamed up that are euphemisms for counterfeit shares. Don’t be fooled : Unless the short seller has actually borrowed a real share from the account of a long investor, the short sale is counterfeit. It doesn’t matter what you call it and it may become non–counterfeit if a share is later borrowed, but until then, there are more shares in the system than the company has sold.
The magnitude of the counterfeiting is hundreds of millions of shares every day, and it may be in the billions. The real answer is locked within the prime brokers and the DTC. Incidentally, counterfeiting of securities is as
It is estimated that 1000 small companies have been put out of business by the shorts.
PDF (12 Pages): Paper Counterfeiting Stock
ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?
Richard B. Evans, Rabih Moussawi, Michael S. Pagano, John Sedunov
Darden Business School, 3 May 2017
We identify an alternative source of ETF shorting related to the market maker liquidity provision and creation/redemption activities. This “operational shorting” arises due to a regulatory exemption, allowing ETF market makers to satisfy excess demand in secondary markets by selling ETF shares that have not yet been created.
PDF (79 pages): ETF Short Interest and Failures-to-Deliver: Naked Short-Selling or Operational Shorting?
Naked Short Selling: Is it Information-Based Trading?
Harrison Liu, Sean T. McGuire, Edward P. Swanson
SSRN Electronic Journal, 21 June 2013
Citing a widely held belief that naked short selling is not based on company fundamentals, the SEC (2008) has substantially tightened Reg. SHO close-out regulations in an effort to eliminate naked short selling. Contrary to accepted belief, we find that accounting fundamentals are highly significant in explaining naked short sales. Further, naked short sales contain incremental information about future stock prices: Abnormal returns from a long/short trading strategy that buys (sells short) shares with low (high) short interest are more than seven times larger using naked and covered short interest, compared to returns using only covered short interest (15.2 percent vs. 2.1 percent annualized). Our findings show that recent actions by regulators to eliminate naked short sales are likely to impede informed arbitrage and reduce market efficiency.
PDF ( 41 pages): Naked Short Selling: Is it Information-Based Trading?
Canaries in the Coal Mine: How the Rise in Settlement ‘Fails’ Creates Systemic Risk for Financial Firms and Investors
Harold S. Bradley, Robert A. Fawls, Robert E. Litan
Kauffman Foundation, 2 March 2011
Our central conclusion is this: Every fail introduces a cumulative and potentially compounding liquidity risk into the orderly process of settling the $7.5 trillion of security transactions completed each day, which could be especially dangerous during times when financial institutions are short of liquidity (as was true during the financial crisis of 2008).
PDF (18 Pages): Kauffman Canaries in the Coal Mine
Choking the Recovery: Why New Growth Companies Aren’t Going Public and Unrecognized Risks of Future Market Disruptions
Harold S. Bradley and Robert E. Litan
Kauffman Foundation, 8 November 2010
We show here that ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future. In the process, ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges and, in turn, discouraging new companies from wanting to be listed on U.S. exchanges.
Continue reading “Paper: Choking the Recovery: Why New Growth Companies Aren’t Going Public and Unrecognized Risks of Future Market Disruptions”
Fails to Deliver: The Price Impact of Naked Short Sales
Stanford University, 27 September 2010
The effect of naked short selling on asset prices and trading dynamics is a prominent topic of debate among market participants, regulators, and the popular press. This paper evaluates the validity of the claim that naked shorting leads to negative excess returns by creating additional selling pressure. While data on naked short sales is not publicly available, Securities Exchange Commission data on failures to deliver is a strong proxy. Fail to deliver data for 2004 covers a period during which the prevalence of naked short selling was not public knowledge since neither the fail to deliver data nor the Regulation SHO List were publicly available. In excluding information and regulation effects, the analysis presented in this paper isolates potential microstructure price effects.
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Regulation of Naked Short Selling
Congressional Research Service, 31 July 2009
Until the current financial crisis, the SEC did not view short selling of large, blue-chip stocks as a problem. In July 2008, however, the SEC temporarily banned naked short sales of the stock of Fannie Mae, Freddie Mac, and 17 other large financial institutions. On September 18, 2008, the SEC banned all short selling of the shares of more than 700 financial companies in an emergency action that expired on October 8, 2008. On October 1, 2008, the SEC adopted an interim rule requiring short sellers’ brokers to actually borrow shares to deliver to buyers, within one day after the expiration the normal three-day settlement time frame. The rule was made permanent on July 27, 2009, and it applies to all stocks. This report will be updated as events warrant.
Full Text Online with Links
PDF (10 Pages): Paper CRS Regulation on Naked Short Selling
Naked Short Selling: The Emperor’s New Clothes?
Veljko Fotak, Vikas Raman, Pradeep K. Yadav
University of Oregon, 6 July 2009
Regulatory and media concern has focused heavily on the potentially manipulative distortion of market prices associated with naked short selling. However, naked shorting can also have beneficial effects for liquidity and pricing efficiency. We empirically investigate the impact of naked short-selling on market quality, and find that naked shorting leads to significant reduction in positive pricing errors, the volatility of stock price returns, bid-ask spreads, and pricing error volatility. We study naked shorting surrounding the demise of financial institutions hardest hit by the financial crisis in 2008 and find no evidence that stock price declines were caused by naked shorting.
PDF (51 pages): Naked Short Selling: The Emperor’s New Clothes?
The Counterfeiting of Shares of Fannie Mae and Freddie Mac: Where are Our Regulators and Who are They Protecting?
17 September 2008
Fannie Mae and Freddie Mac are publicly traded Government Sponsored Enterprises (―GSEs‖), a quasi – partnership between the private sector and the government. The shares of the GSEs trading in the public markets have been counterfeited and deliberately manipulated. This is not rocket science; known ownership of the GSEs shares exceeded the number of shares that were available. Counterfeiting shares of the GSEs caused their stock prices to collapse. The regulators turned a blind eye to the takedown, encouraged it or were not effective enough to recognize it and enforce the laws against market manipulation that have existed since the 1930s. The industry and the regulators have little room for a plausible deniability claim that they did not know what was occurring in the trading of the GSEs.
PDF (33 pages): The Counterfeiting of Shares of Fannie Mae and Freddie Mac: Where are Our Regulators and Who are They Protecting?
Brief Chronology of SEC action on Naked Short Sales over 70 Years, 1938 – 2008
15 September 2008
This paper highlights key SEC actions taken on Naked Short Sales.
PDF (2 pages): Brief Chronology of SEC action on Naked Short Sales over 70 Years, 1938 – 2008
The Economics of Naked Short Selling
Christopher Culp and J. B. Heaton
Despite the cries of alarm, we believe that naked short selling
is unlikely to have significant detrimental effects on capital markets.
In this article, we will first examine the relevant economics
and regulation, and then argue that, from an economic perspective,
naked shorting is little different from traditional shorting.
PDF (6 Pages): Paper Economics of Naked Short Selling
Continue reading “Article: The Economics of Naked Short Selling — The Koch Brothers Approve!”