SHO Us the Money
- By Amy Vincent
- Published 07/16/2009
- Finances
- Unrated
There are many ways to defraud others in securities exchanges. Some are easy to recognize and prosecute. Others are not. Practices such as short selling and naked short selling have the potential to greatly swindle investors, but currently there is no way to track or regulate these transactions.
The short selling of securities is a legal trading method where a broker or buyer borrows securities from a shareholder. The trader then sells and delivers the borrowed securities to a buyer. Naked short selling is a similar practice, but the securities are sold to buyers without first being borrowed from a shareholder. Oftentimes these securities are not delivered by T+3 (the day the transaction was made plus three business days), and the delivery is considered failed.
While a failure to deliver securities may seem obvious, oftentimes it is not so clear cut, because the buyers account will be credited with a “securities entitlement”, which may be represented to be the real thing, even though it is of no actual value.
Regulation SHO
The Securities Exchange Commission or SEC has tried several times to combat failures to deliver. In 2004 they implemented Regulation SHO to create uniform delivery and tracking requirements.
The SEC has also recently proposed changes to Regulation SHO (SEC Release No. 34-59748, File no. S7-08-09, Amendments to Regulation SHO), to address two approaches in short sale trades, the reinstatement of the uptick rule, which prohibits short selling securities unless there is an uptick, and the circuit breaker concept that would either ban the short sale of a security for a day or impose a price for the security.
While these proposed changes, are a step in the right direction, there is another, larger issue being overlooked. The clearing and settlement of these securities trades lacks a system of checks and balances.
The process of naked or hypothecated short sales is a complicated and far-reaching mess that begins at order placement, continues on to order coding, to actions at market, to hypothecating policies, to failed software systems and attempts to settle transactions without knowledge of share status, to entitled settlements and beyond.
The Clearing and Settlement Process
When a corporation enters the public market, it is required to designate a transfer agent to keep track of its control book and shareholder records. This transfer agent is then solely responsible for tracking the share positions of each of the corporation’s registered shareholders. Oftentimes trades of a corporation’s shares will be in made in “street name” or in the name of the broker or transfer agent.
The Depository Trust and Clearing Corporation or DTCC handles the delivery of all shares traded in street name. The DTCC includes these street name securities in their daily balance and considers them to be an equally tradable or fungible mass. This mass of securities is then delivered to their buyers.
This delivery process used to run smoothly when securities were primarily certificated and/or presented to the transfer agent for balance validation. The prominent use of electronic book-entry shares, however, has significantly muddled the delivery process of these undefined, fungible mass shares. The DTCC has exasperated delivery problems by bypassing the presentation of securities to transfer agents for balance verification. Any entitled, but not delivered, securities are kept out of the transfer agent’s purview.
Convoluted Processes
To further complicate matters, the SEC re-defined “security” from the federal securities laws to “security” as defined under individual state’s Uniform Commercial Code or UCC. The SEC has also made it legal for brokers-dealers to credit customer accounts prior to the actual delivery of the security. The credit or securities entitlement allows for DTC and their participants to hide the actual amount available for trading.
Currently, when a short sell trade takes place, the order must note whether the holder is “long” the shares (the holder owns the security) or is short. If short, the lender must be identified prior to settlement. If the shares are borrowed, the order is coded “entitled” to shares, instead of long the shares.
These entitled shares are then treated the same as those that will actually be delivered in T+3, but the actual delivery of these shares is not tracked. Even though there is a theoretical time frame by which the situation must be righted, if there is a failure of delivery, there is no ability to track when that time frame has passed, and interest can continue to be paid to the lender, without limit.
The borrower is deemed settled, and can sell these non-existent securities and brokers are often paid whether or not the shares are ever truly delivered.
Tracking and Transparency
Currently, there is no transparency or tracking built into the securities trades in the clearing and settlement system. To aid the tracking and transparency process for short sales, the following could be implemented:
* Security could be re-defined to exclude entitlements from being treated as settled trades.
* All sales transactions could be coded as long or borrowed.
* Each entity involved in a trade could have an individually assigned number attached to their trade order/request/confirmation, etc.
* Settlements must occur at T+3 or sooner.
* When shares are delivered, both the lender and the receiver should note the delivery.
* Replacement securities should have the same aggregate value.
* No replacement securities credited to customers (when customer securities are hypothecated) should be guaranteed or issued by market participants or others.
* NMS securities, that fulfill all registration requirements, could be credited as replacement securities to customer accounts. Cash could be used too.
* Brokers would debit the securities they hypothecate from customer accounts.
* Customers could become the beneficial owners the securities provided in lieu of the hypothecated securities and maintain full control over them.
* Those who violate the rules could be held accountable and penalized.
If these suggestions were implemented, the process of naked short selling could be monitored and tracked to ensure that no one received the short end of the stick.
The short selling of securities is a legal trading method where a broker or buyer borrows securities from a shareholder. The trader then sells and delivers the borrowed securities to a buyer. Naked short selling is a similar practice, but the securities are sold to buyers without first being borrowed from a shareholder. Oftentimes these securities are not delivered by T+3 (the day the transaction was made plus three business days), and the delivery is considered failed.
While a failure to deliver securities may seem obvious, oftentimes it is not so clear cut, because the buyers account will be credited with a “securities entitlement”, which may be represented to be the real thing, even though it is of no actual value.
Regulation SHO
The Securities Exchange Commission or SEC has tried several times to combat failures to deliver. In 2004 they implemented Regulation SHO to create uniform delivery and tracking requirements.
The SEC has also recently proposed changes to Regulation SHO (SEC Release No. 34-59748, File no. S7-08-09, Amendments to Regulation SHO), to address two approaches in short sale trades, the reinstatement of the uptick rule, which prohibits short selling securities unless there is an uptick, and the circuit breaker concept that would either ban the short sale of a security for a day or impose a price for the security.
While these proposed changes, are a step in the right direction, there is another, larger issue being overlooked. The clearing and settlement of these securities trades lacks a system of checks and balances.
The process of naked or hypothecated short sales is a complicated and far-reaching mess that begins at order placement, continues on to order coding, to actions at market, to hypothecating policies, to failed software systems and attempts to settle transactions without knowledge of share status, to entitled settlements and beyond.
The Clearing and Settlement Process
When a corporation enters the public market, it is required to designate a transfer agent to keep track of its control book and shareholder records. This transfer agent is then solely responsible for tracking the share positions of each of the corporation’s registered shareholders. Oftentimes trades of a corporation’s shares will be in made in “street name” or in the name of the broker or transfer agent.
The Depository Trust and Clearing Corporation or DTCC handles the delivery of all shares traded in street name. The DTCC includes these street name securities in their daily balance and considers them to be an equally tradable or fungible mass. This mass of securities is then delivered to their buyers.
This delivery process used to run smoothly when securities were primarily certificated and/or presented to the transfer agent for balance validation. The prominent use of electronic book-entry shares, however, has significantly muddled the delivery process of these undefined, fungible mass shares. The DTCC has exasperated delivery problems by bypassing the presentation of securities to transfer agents for balance verification. Any entitled, but not delivered, securities are kept out of the transfer agent’s purview.
Convoluted Processes
To further complicate matters, the SEC re-defined “security” from the federal securities laws to “security” as defined under individual state’s Uniform Commercial Code or UCC. The SEC has also made it legal for brokers-dealers to credit customer accounts prior to the actual delivery of the security. The credit or securities entitlement allows for DTC and their participants to hide the actual amount available for trading.
Currently, when a short sell trade takes place, the order must note whether the holder is “long” the shares (the holder owns the security) or is short. If short, the lender must be identified prior to settlement. If the shares are borrowed, the order is coded “entitled” to shares, instead of long the shares.
These entitled shares are then treated the same as those that will actually be delivered in T+3, but the actual delivery of these shares is not tracked. Even though there is a theoretical time frame by which the situation must be righted, if there is a failure of delivery, there is no ability to track when that time frame has passed, and interest can continue to be paid to the lender, without limit.
The borrower is deemed settled, and can sell these non-existent securities and brokers are often paid whether or not the shares are ever truly delivered.
Tracking and Transparency
Currently, there is no transparency or tracking built into the securities trades in the clearing and settlement system. To aid the tracking and transparency process for short sales, the following could be implemented:
* Security could be re-defined to exclude entitlements from being treated as settled trades.
* All sales transactions could be coded as long or borrowed.
* Each entity involved in a trade could have an individually assigned number attached to their trade order/request/confirmation, etc.
* Settlements must occur at T+3 or sooner.
* When shares are delivered, both the lender and the receiver should note the delivery.
* Replacement securities should have the same aggregate value.
* No replacement securities credited to customers (when customer securities are hypothecated) should be guaranteed or issued by market participants or others.
* NMS securities, that fulfill all registration requirements, could be credited as replacement securities to customer accounts. Cash could be used too.
* Brokers would debit the securities they hypothecate from customer accounts.
* Customers could become the beneficial owners the securities provided in lieu of the hypothecated securities and maintain full control over them.
* Those who violate the rules could be held accountable and penalized.
If these suggestions were implemented, the process of naked short selling could be monitored and tracked to ensure that no one received the short end of the stick.
Amy Vincent
By Amy Vincent, sponsored by First American Stock Transfer, Inc., registered with the Securities & Exchange Commission as a Registrar and Stock Transfer Agent - http://www.firstamericanstock.com. Please link to this site when using this article.
View all articles by Amy Vincent