When Liquidity and Market Protections Clash

Some more stuff on naked short selling from investigatethesec.com, the emphasis is ours. The (nakedly) shorting hedge funds are planning various routes out of the upcoming legislation to require them to pre-borrow. Naked day-trading is one. Was it Nancy Reagan that used to say “just say no”?

When Liquidity and Market Protections Clash –  July 31, 2008
David Patch

As the SEC mulls over what actions next to take on short sale reforms, hedge fund lobbyists canvas Washington with threats in hand seeking for relief from fee induced rule making associated with a short sale trade.

According to reports, day-trading hedge funds are lobbying for the Commission to scrap all aspects of the pre-borrow rule in a short sale due to the cost increase such rule making will have on the overall short trade.  Some of the more well known funds impacted would be a SAC Capital managed by Billionaire Steve Cohen, Citadel Investment Group managed by an equally wealthy Ken Griffin, and Kynikos Associates managed by mere millionaire James Chanos.

At issue is whether these large funds should have access to day-trade short equity stocks without the expense of paying a fee for the rights to sell what they do not possess.  To state their case, these funds have hired former US Representative and former Chairman of House Financial Services Committee on Capital Markets Richard Baker now president of Managed Funds Associates.

Under present law, a typical short sale will consist of a locate prior to the trade being executed and only after the trade is executed is the seller obligated to seek out and borrow that share for delivery.  In the present T+3 settlement system, this borrow is not required until the T+2 or T+3 trade date allowing several days  ‘grey area’ where a sale is executed but what was sold is not in possession of the seller.

Should the SEC proposed rules of a pre-borrow become law, the short seller in this case would not be afforded this grey area and will instead carry the burden of cost to borrow from trade date until such time as the short sale is covered in the market.  To the short seller who plans on making this short interest a long term trade investment the added days are trivial to the long term carrying costs of the stock borrow.

To the day trading funds the story is not so cut and dry.

Most recognize SAC Capital as this big elephant in the room that comes in and out of markets in fast trading succession.  It is not about the company or the market; it is about the opportunity to trade on created volatility.

SAC Capital will sell short and cover huge volumes of stock in a single day profiting from the difference between the short sale and the covered costs.  Trading such as this carries no burden cost of a stock borrow because the rapid trading is concluded, the position closed, well within the normalized trade settlement window.

SAC and others large funds anticipate that their presence in a market, with plenty of capital behind them, can create enough chaos to generate the volatility necessary to turn a profit.  The initially short sales, in rapid succession, will create fear and panic as bids are raided and that fear and panic will drive investors out at which point the short sale is covered for a profit.  This process is repeated over and over as the market equilibrium slowly falls.

The profit margins on a trade such as these can be huge as even with regards to hard to borrow stock, no borrow is necessary to execute the tradeFunds that trade in this manner have become market makers without the requirement to maintain order.

Funds that trade in this manner have the intent on creating market chaos.

Those that now lobby our members of Congress and Federal Regulators are crying foul on reforms that would have these trades incur the added expense of a stock borrow.  The funds firmly believe that in doing so the cut in profit margins would be significant enough to make the trade risky.

Funds like SAC Capital and Kynikos don’t like to trade with risk.

The more basic issue Congress and regulators should be discussing is why such traders are afforded the opportunity to trade in this manner at the possible expense of the health of the capital markets and those who invest in these markets; To trade like market makers without the oversight of market makers.

On point, I do not consider a day trader who flips trades over the course of a few hours an investor. These traders are gamblers and when these gamblers are represented by funds the size of SAC Capital they come in carrying the house odds and not the gamblers.

Market makers are provided an exemption from the locate rule applied to a short sale in order to sell naked short for ‘bona-fide market making’ activities.  While these activities are loosely defined, the market makers are intended to flatten out the instabilities in a market by taking on a contrarian trade to that of a sudden burst in one sided market sentiments.  If the markets are suddenly being overwhelmed in selling the market makers will step in and create liquidity by buying shares and when buyers come in excess the market makers sell naked short to insure stability is maintained in the markets.

The market makers are regulated, weak as it may be, in this type of trade activity.

Hedge Funds are afforded no exemption and yet today, without the pre-borrow they trade essentially the same way.  The difference however is that order is not the intention of their trade, chaos is.

Without the requirement to borrow that share located immediately after a trade is executed the short seller can re-use those shares multiple times in a single day and multiple times across multiple brokers.  Because a short seller is required to locate only the share being used as a locate is nothing more than a bookmark.  The fact that laws do not presently demand a stock borrow this allows the short seller to re-use the same share to sell a stock without paying any type of premium for the use of that share.

The intent of the short sale laws, in place for 60 years, is to make sure that what is being sold is being delivered and when selling something you are selling something within your possession to deliver; whether it by through a borrowed share at a fee or an actual share purchased.  Never intended was to sell something you will never possess and profit from it.

As former Congressman like Richard Baker lobby for the rights of a short seller to act as a market maker freely and unregulated understand his efforts are not in the interests of the investing public who do invest for the long term [long or short] or for those public companies caught in the firestorm of these hedge funds.

The ability to day trade in and out of these markets through the use of computers has aided hedge funds in destroying confidence in public companies.  Their actions are not transparent to the markets but their actions are the very actions that move them to where they go.  These funds seek out an ounce of possible negativity in a market and make those in the market fear that it is something much worse through rapid naked shorts executed as day trades.  By the time the investors realize what is happening their investments have collapsed and panic selling ensues.  In the end it was the day trader that profited and the long investor who booked the loss.

Prior to the collapse of Bear Stearns and the near collapse of several other financial institutions this was an accepted behavior amongst regulators.  Hedge Funds created liquidity, even if it was simply intra-day day trading, and liquidity was king.  Now it is being recognized for what this liquidity really is, a means to manipulate markets.

In 2004 former Chairman William Donaldson spoke before Congress and asked “How much fraud are you willing to accept for liquidity”; Congress blinked.  Today that very same question is being asked of Congress again and the jury is still out on whether they will again blink in the face of the investing public.

Fearing that the SEC is not capable of making the right decision on their own, it is imperative that Congress draft legislation that ties the hands of the agency and forces short sellers to have in their possession the very article for which they plan to sell.  Nothing short of a pre-borrow will protect these markets from the predators of Wall Street; the billionaire hedge fund managers and their wealthy clients who simply need more.

[In other words, shareholdersunite!]