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Fraud in the financial markets - is it really that bad?

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Some interesting comments from readers of the Wall Street Journal blog:

 

http://blogs.wsj.com/marketbeat/2008/07/17...-selling-spike/

 

 

Don't know to what extent the same thing happens here in FTSE listed shares, but has made me realise how corrupt the whole financial system is generally both in the US and here in the UK.

 

 

Naked shorting is not done by individual or institutional customers. It is done by brokers, who put you in a short position, but fail to properly borrow the stock before they do it. Because the SEC never enforced the rule against naked shorting, brokerage houses generally have not bothered to comply with it. Instead of searching for specific stock to borrow, they just assume that the stock exists, and establish the short position for the customer. SEC put them on notice that they are going to be enforcing with regard to shorts taken on the Fed’s primary dealers. That caused paranoid brokerage houses to close out short positions, refuse to allow customers to sell short, and has ended up creating the biggest short squeeze in history. Some short sellers who have been forcibly closed out of positions may have the right to make a claim against their brokers, who failed to properly borrow the stock, and then panicked, causing the customer take the loss. Meanwhile, the Fed and its primary dealers have gotten exactly what they wanted…a dead cat bounce of huge proportions.

 

I should also note that nobody ever does anything about the huge naked shorts in the silver market. The identity of these short sellers is being withheld by the CFTC, but they are generally assumed to be the big investment banks. Yes, that’s right. They may very well be the same folks who are complaining about naked shorting on the stock market. They rarely, if ever, pay off on silver futures contracts, so, investment banks have taken short positions equal to several times the entire world supply of silver. They issue huge amounts of paper promises to deliver silver that they don’t have. This artificially reduces the silver price, while they collect huge premiums. It is easy for the bankers to first sell the futures contracts at a premium, and then, later, flood the market with more paper silver, which reduces the price, so that the contracts can be bought back, without delivery of any metal ever taking place. Naked silver shorting is certainly taking place, and it is one of the most abusive activities in the markets today. Yet, the government does nothing, because the Fed wants silver and gold to fall in price, out of fear that they compete, potentially, with the dollar. In contrast, they want the stock market to rise. The demand for silver and gold is so high, that in spite of naked shorting, both keep rising in price. If not for the naked silver shorts, however, the silver price would be about $30 per troy ounce now.

 

I have short sold before. However, I think it is morally repugnant, just like bribery, lying, cheating, etc. It is a rip off of the current owners and results in wild sell offs followed by short covering rallies. It encourages market participants to wait for a final blow off selling event before they reenter to the market. What a bunch of bullsh[]t this is. Without short sellers, this blow off selling event might not occur. Market participants would be forced to participate based upon fundamentals and not some technical blow off or whatever. This leads to wild fluctuations and might even cause the Fed to intervene when they might not have to intervene. It is a fools game that is costing us more over the long run. (Kind of like having lawyers around. They cost you more than you might think even though they aren’t suing you directly. It is a hidden cost. Aren’t there really enough costs to go around?)

 

When you sell short without borrowing the shares you are counterfeiting shares and selling them. These shares don’t exist. If they did you could find them and borrow them. Naked short selling creates new shares that the company did not issue and expands the number of shares outstanding creating additional supply of shares to the market. Prime brokers collude with hedge funds to create this excess supply of unissued shares to drive the price of the stock down and increase their profits. This is not a simple case of trading techniques that need to be regulated. Its as if the hedge fund had its own printing press to print out as many shares as it wants to sell driving the price down. It also distorts voting rights and dividend rights. Who can vote shares if the registered buyers shares outnumber the shares issued? Who gets the dividend? It is fraud pure and simple and the SEC’s refusal to enforce even simple regulations like this is an outrage.

 

I hadn't realised it was quite as bad as this :(

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I hadn't realised it was quite as bad as this :(

 

I have a lot of misgivings about the practice of short-selling - whether this is naked or otherwise.

 

I'd be miffed if shares I think I own are sold while borrowed from me... especially if they are borrowed without my knowledge without my reimbursement.

 

Naked shorting seems an improvement - not something more criminal - since it does not influence the market value of the shares themselves.... the people who believe that they own shares really do.

 

Shorting itself is peculiar... it doesn't benefit humanity in the same way as financing a competitor would do... and if one borrows a share to sell it short - unless the owner of that share is fully aware that they have lent it - and feel suitably compensated - I think it flies in the face of the principle of ownership that is usually cited to validate property in the context of capitalism.

 

I think a far fairer situation would arise if we allowed naked shorting (where suitable regulation mitigates risk of default) and there were to be a minimum requirement of opt-in to allow shares to be lent.

 

On a related note, I suspect that this is a significant problem with index trackers... am I in any way assured that an investment in a tracker will create demand for the underlying investments? It seems, to me, that a whole lot of the most accessible investments are not quite what they seem.

 

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Thanks and wow - that really was an eye opener!

 

Any chance you can post the other articles as and when they become available?

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Naked shorting seems an improvement - not something more criminal - since it does not influence the market value of the shares themselves.... the people who believe that they own shares really do.

 

Naked shorting is used to drive down the market value of the underlying security --- not sure where the does not influence value of the shares comes from. Also 'the people who believe that they really own shares really do' -- until they find out they don't !!

 

Listen to this for many examples of naked shorting, plus the initial 4 episodes should you feel inclined.

 

Crime of the Century - Part V:

Summary & Conclusion with Eric King: http://www.netcastdaily.com/broadcast/fsn2008-0621-3b.mp3

 

Do you really own shares ??

 

Dark Side of the Looking Glass.

http://www.businessjive.com/

 

.

 

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Naked shorting is used to drive down the market value of the underlying security --- not sure where the does not influence value of the shares comes from. Also 'the people who believe that they really own shares really do' -- until they find out they don't !!

 

Maybe I entirely failed to grasp naked shorting, but that argument doesn't make sense to me.

 

Naked shorting:

 

Short-view-investor : buys a short for 1m Acme Corp. shares.

Long-view-broker : accepts the risk and takes the bet. No shares borrowed; no shares sold on the open market - perhaps this risk is hedged by selling a long derivative.

TIME PASSES - this trade doesn't affect the market for real Acme Corp. shares.

If other activity leads the share price lower (i.e. when owners of the shares decide or are forced to sell) then the short-view-investor wins money from the broker, while the short-view-investor looses if the share price stays high.

 

"Proper" shorting

 

Short-view-investor : buys a short for 1m Acme Corp. shares.

Long-view-broker : obeys the rules and borrows 1m Acme Corp shares from the ISA portfolios he manages... replacing them with long contracts - and sells the real shares.

TIME PASSES - 1m entirely new shares affect supply/demand for ownership of Acme Corp - suppressing their share price.

If the share price is lower, then - when the short is closed, the broker can buy shares for his ISA portfolios and swap them again with the long contracts... passing the 'profit' to the short-view-investor.

 

With Naked Shorting, the short-seller is "short-changed" (pardon the pun) but the ISA investor is respected. With "Proper shorting" the ISA investor is exploited; the value of his holding is suppressed artificially (by an increased number of shares being available to other ISA customers) and he has no comeback and the broker takes no risk.

 

My take is that "proper" shorting is less ethical than naked shorting... though both have the potential to deceive customers of the broker.

 

Do you really own shares ??

 

Me personally? Nope... I've no physical numbered share certificates...

 

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aSteve,

'no shares sold on the open market ' seems to be the key phrase.

 

If no shares are sold on the open market it is not naked shorting - that is a bet between broker and client which I'm not even sure if that is allowed -- I would doubt it.

 

Naked shorting is when the 'transaction' is registered in the market and therefore affects price.

 

Take the example from crime of the century 5 where the hedge fund is naked shorting to drive a share price down, they damn well want to see the volume they're selling registered on the exchange to drive price down and worry other investors. In other words those transactions are registered on the relevant exchange therefore selling shares that do not exist into the open market.

 

.

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If no shares are sold on the open market it is not naked shorting - that is a bet between broker and client which I'm not even sure if that is allowed -- I would doubt it.

 

Naked shorting is when the 'transaction' is registered in the market and therefore affects price.

 

Take the example from crime of the century 5 where the hedge fund is naked shorting to drive a share price down, they damn well want to see the volume they're selling registered on the exchange to drive price down and worry other investors. In other words those transactions are registered on the relevant exchange therefore selling shares that do not exist into the open market.

 

Naked shorting... is being described as something subtly different to what I previously understood.

 

I'm watching the businessjive presentation... It seems I'm saying that what he considers "Naked Shorting" is just as unethical as "Proper shorting" - since in both circumstances someone is lead to think that they have shares - when, in fact, they don't... It doesn't matter in my view if these non-shares that are mistaken for shares are FTD notes, or OTC long derivatives. The point is that there is a deception. If the broker has access to managed funds, they are extremely likely to use those to their own profit without reimbursing the supposed share owner.

 

This is the issue I have with shorting... even when the shares are borrowed, are the people who own them the lenders - or is it the brokers/fund managers who are entrusted to keep these shares safe.

 

I think that a bet between two market participants is allowed - this is what I understand an OTC derivative to be.

 

P.S. I really liked the "Darkside of the Looking Glass" presentation... it filled in a number of details - though I was already aware of the big picture. I'm not sure it is an apocalyptic situation - but I always thought it was 'bent'.

 

This presentation has set my mind thinking... the whole "FTD" thing is remarkably neat... and I'd always assumed that shorts would be borrowed by substitution of OTC long contracts... which I'd consider dubious too. The thing that the presentation doesn't attempt to do is to determine either the size of the short market and to compare that with the number of shares deemed 'borrowable'. It strikes me that this might well give a better insight than that from FOIA disclosures.

 

As I think further, this is an old scam which, essentially exploits the difference between an asset and a synthetic asset - i.e. an asset that appears to have collateral value and one that just generates a similar cash flow. I wonder if a similar situation might not arise with "bonds" - be these mortgage/asset backed securities or commercial debt... there definitely is such a thing as a synthetic... I wonder if synthetics have been swapped into the place of bonds in the portfolios of pension companies, for example? If this has happened, the real bonds could be used for additional borrowing... while the synthetic can not be. Of course, this is just an abstract thought - I've no evidence - but I think they'd be interesting questions to pursue.

 

 

 

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I m considering just to invest for yield-only at some point in the future - shareprice and thus manipulation will not matter.

 

Dividend Yield will force the shareprice to re-correct at regular points in the year. It may even deter shorters.

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When you short a share, your broker is supposed to borrow that share from someone who owns it, and then sell it for you to someone who has placed a buy order. In the US, shares may only be borrowed from margin accounts, not cash accounts - I do not know the situation in the UK. It is deemed that you have consented to having your shares borrowed by holding them in a margin account.

 

If you "naked" short a share, the share that you are selling is never borrowed. It is replaced by an indicator of ownership - the end buyer (since you are the seller, there must be a buyer) thinks they own the shares, but they don't.

 

Both of these acts obviously increase the supply of shares, and therefore will have some impact on the price, but the latter has no limit, unlike the former, where there are only so many shares in margin accounts to borrow. (And those who invest in penny stocks would be very unwise to use margin.)

 

For what it's worth, while Puplava & co. definitely believe this is a big issue, the brokers I have spoken to are unconvinced.

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For what it's worth, while Puplava & co. definitely believe this is a big issue, the brokers I have spoken to are unconvinced.

 

If it were a massive problem that enriches brokers, I'd not be surprised if they all sound unconvinced. ;)

 

I approached this question from a different perspective. I asked myself this: if shares need to be borrowed in order to be shorted, then they must have rental value. If I want to engage in this business, how do I do that? How do I own a share and dictate my minimum price to rent my share from me in order to short it? If I can't collect rent on my property when someone borrows it, is it my property in the first place? If there is no market to determine the fair rental price, how can any short properly reimburse the owner of the share for the privilege of borrowing the share? The absence of a free market to determine the rental price of shares strongly suggests to me that there is something fundamentally underhand going on. The least damning remark I can make is that market for shorts can't be efficient.

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If it were a massive problem that enriches brokers, I'd not be surprised if they all sound unconvinced. ;)

 

I approached this question from a different perspective. I asked myself this: if shares need to be borrowed in order to be shorted, then they must have rental value. If I want to engage in this business, how do I do that? How do I own a share and dictate my minimum price to rent my share from me in order to short it? If I can't collect rent on my property when someone borrows it, is it my property in the first place? If there is no market to determine the fair rental price, how can any short properly reimburse the owner of the share for the privilege of borrowing the share? The absence of a free market to determine the rental price of shares strongly suggests to me that there is something fundamentally underhand going on. The least damning remark I can make is that market for shorts can't be efficient.

 

Well, all of this is highly regulated, and regulated markets are in general inefficient. I don't personally know if there is skulduggery beyond the regulation. In the US, you can opt out by using a cash account, though I believe that also means you can't trade stock options.

 

The argument for shorting is that is helps the price of the shares reach equilibrium sooner, and that seems plausible to me. Note that ordinary shorting has very substantial risks such that if you are not good at it, you are going to go broke. And if you are good at it, that would imply your negative opinions of companies at certain prices were correct.

 

As for the brokers - the ones I referred to specialized in small-cap stocks, mostly resource. They have also heard all the excuses incompetent management can give for the poor performance of the stock prices of their companies.

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Well, all of this is highly regulated, and regulated markets are in general inefficient. I don't personally know if there is skulduggery beyond the regulation. In the US, you can opt out by using a cash account, though I believe that also means you can't trade stock options.

 

I am entirely unconvinced that regulated markets are necessarily inefficient... unless, for some reason, deception is necessary for efficiency.

 

I can see two ethical stances that are consistent with capitalism:

 

1. Shorting of shares is prohibited - it is only possible to short shares by selling the ones you own.

2. Shorting of shares is promoted - and there is a market price for share rental.

 

Anything else, as far as I can see, necessarily either requires

 

1. Over-paying for shares that might be shares or might be IOUs - and hence have near-zero capital value... or

2. Having a breech of fiduciary duty by brokers who hold shares on behalf of their clients by not getting the best rental price for the loan of shares in the market.

 

To an individual the effect is minimal - but when we consider that, say, 30% of a stock might be out on loan, it makes it remarkably likely that this will affect the capital value of the stock. I can trade a long position in a share on margin - if we assume a margin of 10%, this means that I've been over-charged ten-fold if I buy a share at full price and have no idea if it is a share or a long position (i.e. an IOU for which I receive the same dividends as a real share.)

 

I see this as being at least as big a problem as naked shorting. If the argument that short selling improves market efficiency, then why should we not allow all shares to be borrowed? If permission is required from the owner, how would I - as the holder of an Equities ISA, having bought shares at full price, establish if my shares are currently on loan?

 

 

 

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Maybe I entirely failed to grasp naked shorting, but that argument doesn't make sense to me.

 

[snip incorrect explanation]

 

You've not got it quite right.

 

'Real shorting'

 

1. ACME Pension Fund Ltd. holds 1,000,000 shares in XYZ Plc. Managers have no intention to sell these for a very long time.

2. Mr Short Investor asks his broker to short 10,000 shares.

3. Broker calls up APFL and asks for a loan of 10,000 shares. Broker pays A a moderate fee (typically about 2.5% per annum) and shares are handed over to broker.

4. Broker lists shares for sale in the open market.

5. Shares are sold, cash is held in a restricted account as collateral.

6. SI instructs B to close his position. B buys 10,000 shares in the open market and returns them to A.

 

Everyone is happy. Mr short gets his investment. Broker gets his commission. A gets their shares back and received a fee for loaning them amount (they also get their dividend payments too - directly from Mr short's pocket).

 

'Naked shorting'

 

0. When shares are dealt - a receipt for the shares is issued immediately, but the share certificates (or electronic proof of shareholding) is not delivered for 3 working days.

 

1. Mr Naked short (most likely also a broker) advertises 10,000 shares for sale on the open market, even though he does not own, nor have in his possession, such shares.

2. Mr Long investor sees the shares for sale and contracts to buy them. He is issued a receipt for the transaction, and advised that the certificates will follow in 3 days.

3. Stock exchange records this transaction as if it were a normal transaction. Neither the buyer nor the market know that actually no such shares exist.

4. Mr naked short now has a problem - he needs to get hold of some real shares in order to honour the deal. He has 3 options:

a - He can buy the shares on the open market

b - He can contact a pension fund, or other long term investor, and request a loan

c - He can do nothing (or he can try and fail to do a + B) and break the contract. This is called 'failed to deliver'.

5. If he does b, then the position is converted into a normal short position. If he does a, then his position is closed.

 

With normal shorting, if a share is heavily shorted, then it may prove difficult or impossible to secure shares on loan. E.g. if in the first example, Mr S is jumping on the bandwagon rather late in the day, then A may have lent out every single one of thier XYZ shares. If this is the case, then Mr S cannot take a short position. This places a limit on the number of shares that could possibly enter the market.

 

In naked shorting, shares are not borrowed. There is therefore no limit to the number of 'shares' that can be dumped on the market at any time. This gives great potential for abuse, as a major player can simply claim to have millions of shares - collapse the price by flooding the market, forcing longs to panic and bail out. The buy back the shares he sold from a panic striken market.

 

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I see this as being at least as big a problem as naked shorting. If the argument that short selling improves market efficiency, then why should we not allow all shares to be borrowed? If permission is required from the owner, how would I - as the holder of an Equities ISA, having bought shares at full price, establish if my shares are currently on loan?

 

Im not sure you could. However, as your shares would (or should) be held in a nominee account, you are listed as the benficial owner, and your permission would be required to loan them out. It's up to the 'custodian' that holds the shares in their account as to whether they are loaned out or not. In general, for private stock accounts, they wouldn't be interested as the sizes are likely to be too small - but for institutional investors (with many $million in stock), they may be able to negotiate lease rates, etc.

 

However, Margin accounts (either stock accounts as in teh US, or CFD accounts in the UK) work on the principle that if you want to trade on margin, you need to help make it work - so for any stock bought with margin in the US may be loaned. In the UK, margin accounts use CFDs (a type of OTC derivative) which are legally separate to the underlying share - you do not own, and do not have control over the actual share purchase (indeed there is no requirement that your purchase of a CFD be met by an underlying purchase of a share on the open market).

 

As regards funds, you would need to check in the prospectus. I'm fairly sure that ETFs (both equities and physical metals) do not allow their contents to be loaned (although this does not prevent the actual ETF shares being loaned or shorted). For mutual funds you would need to check individually - for mutual long-short funds, then these funds usually purchase both stock and CFDs (for long positions) so the CFD component will likely operate as above.

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