Short selling is a huge enterprise on Wall Street as carried on by aggressive and often predatory hedge funds. Stock lending to facilitate short selling is a huge and profitable business for the elite Wall Street firms like Goldman Sachs, Morgan Stanley, Merrell Lynch, et al and has been estimated to account for as much as 20% of their net income.
How has the losing game of short selling been changed into a winner’s game? Certain hedge funds have been able to use illegal naked shorting combined with other tactics to make short selling a winner’s game. In many cases hedge funds acting through collaborating market makers can create huge numbers of counterfeit shares that can overwhelm demand. Illegal naked shorting also takes away or reduces a major disadvantage of short selling and that is the borrowing costs.
If you are not actually borrowing shares, there is no actual borrowing cost. However, the hedge fund is not the one creating the counterfeit shares. It is the market makers and they can demand a borrowing cost even if they don’t locate shares to borrow and just create counterfeit shares. This counterfeit borrowing cost is much reduced from what a legitimate locate and borrow would cost. This allows for (illegal) shorts to be maintained for a much longer period of time.
Short selling and the associated business of stock lending is a huge business. Why is that? You probably know by now that I think that both legal shorting in conjunction with illegal naked shorting are extensively used on Wall Street to manipulate stock prices downward and trade around a predictable downward trend in the stock price. This converts the loser’s game of short selling into a highly profitable, low risk investment strategy (scam).
I have observed in which I have seen and others have seen inexplicable drops in stock prices that are clearly consistent with market manipulation. The other is the DTCC and its participants can easily use the current clearing and settlement system and ineffective regulations riddled with loopholes to create counterfeit shares and also to hide their trading activity. The DTCC is a self-regulating organization which means that there is no one, including the SEC, who has a good understanding of what they and their member firms are doing.
When most investors look at their brokerage statement, they think that they own registered stock of the companies they have invested in. A registered holder is a shareholder who holds their shares directly with a company and have their names and addresses recorded in the company's share registry maintained by a transfer agent. Public investors don’t. They actually own a financial derivative of registered shares. Their brokerage firm is the nominee that holds the securities listed in their account in street name. Investors receive the financial benefits of registered stock ownership such as dividends and also can vote on all corporate affairs, but they don’t own the street name securities. Adding to the complexity, street name shares are a financial derivative of actual registered shares, all of which are owned by Cede, a subsidiary of DTCC.
Investors own a derivative security of a derivative security of the actual registered shares owned by Cede. The designers of the system largely were Wall Street firms who convinced government legislators and regulators that this is critical to the admittedly very effective system we now have. This was done to immobilize and dematerialize registered stocks in order to create a liquid market capable of trading billions of shares per day while virtually eliminating settlement risk. This objective was accomplished, but at the cost of making investors buy a financial derivative of a registered stock instead of actually owning the stock. They own fungible financial derivatives of registered stock or said another way, they own untraceable commodities.
Brokers clear and settle through a very different process called continuous net settlement. When we buy or sell a share of stock, our broker executes the trade in street name securities. It is important to understand that the broker under net continuous settlement is almost never matching a buy order with a sell order, but is buying and selling from its inventory. They next credit or debit our account with a “second derivative to registered stock” security. This results in total lack of transparency to outsiders about who is buying or selling stock, but internally DTCC can track this in real time.
The biggest beneficiaries of stock lending are brokers.brokers are making enormous profits without sharing them with customers who theoretically should be entitled to the bulk of the economics. Even worse, this goes against the economic interest of the broker’s customers. These securities are lent to investors who want to drive down prices and sometimes use short selling (and illegal naked short selling) to manipulate stock prices down.
Reg SHO allows naked shorting of stocks by a market maker. This means that a market maker when given an order to short a stock can complete the trade without locating stock to borrow. Reg SHO allows the market maker two days until settlement (T+2) to locate stock to borrow. Actually, Reg SHO allows bona fide markers (whoever they are) to have six days (T+6) to locate shares to borrow.
If they cant then it becomes an FTD but they beat FTD’s by using these steps:
Market Maker “A” with the FTD can work in collaboration with Market Maker “B”. “A” locates and borrows shares from “B”. However, “B” uses a naked short to supply the borrowed stock.
“A” no longer has an FTD.
“B” is now naked short the shares and has six days to find a locate.
If “B” does not find a locate, they have an FTD. “B” then can buy the shares from Market Maker “C” who executes a naked short, ad infinitum.
This is called rolling over a position and can be done for a very long time.
Certain hedge funds have been able to use illegal naked shorting to make short selling a winner’s game without it short selling would not be profitable or at leasr not enough to warrant the risk. Hedge funds acting through collaborating market makers can create huge numbers of counterfeit shares that can overwhelm buying demand. They have turned it into a casino and everyone knows the house always wins in that scenario.