That naked short selling is allowed is an anachronism coupled with the lobbying of the self-interested. In the olden days, it was reasonable to give a time delay to deliver the physical paper that proved ownership. Now everything is electronic so _could_ be verified instantly. But there's a lot of money to be made by doing it and the government will covert catastrophic losses, so it should be expected that everyone does it.
Fortunately the solution is quite simple. Force short sellers to make the shares available instantly at the time of the short. They could be held in escrow by the exchange until settlement either way. Go go gadget SEC?
What's the problem with it, really? If A promises B to sell him something and then A can't deliver for some reason, then B will stand to be compensated by A for any damages resulting from that. Why would it be special for stock? Of course there is the risk that massive naked trades will influence the price of stocks, but that should just be priced in, like any other risk, no? What am I missing?
When you're selling something you don't own you're distorting the market's price discovery mechanisms. In many contexts I think most people would consider it fraudulent to sell something before you've bought it.
"When you're selling something you don't own you're distorting the market's price discovery mechanisms."
How? It only does so if one sets out to do it on purpose, and in that case there is no difference between selling something that own, or that you don't (yet) own.
Let's say I sell grain to you for 300 USD per ton, to be delivered in Fall 2012. How does that distort the market? Alternatively, how is this example different from naked selling? Or isn't it, and do you think that this sort of insurances should be prohibited too?
"In many contexts I think most people would consider it fraudulent to sell something before you've bought it."
I'm not sure. There are many retailers who only order something from their wholesaler or manufacturer after you've bought it from them. Why would a buyer be concerned with when or how a seller gets his merchandise? It only becomes a problem after failing to deliver the goods, and when no adequate compensation for such a failure can be given (i.e., a seller going bankrupt because of a naked sale gone wrong). Something that could be controlled, regulated or mitigated in many ways that are much less intrusive than forbidding 'naked shorts'.
I think the confusion here is that 'short selling' is a misnomer - it doesn't involve any merchandise at all.
From the article: "In other words, 107% of all Overstock shares available for trade were short – a physical impossibility, unless someone was somehow creating artificial supply in the stock."
That is to say, there were more Overstock shares in the market than actually existed, because they were borrowed from thin air.
With a retailer, the merchandise will get delivered, and then the buyers will have it forever. With 'naked shorting', the merchandise is created from nowhere, lent out, sold, rebought, returned, and then disappeared. The shares never actually exist. But they affect the market as if they do exist - e.g. more shares existing in a company means every share is less valuable, so by magicking these shares into existence the price is equally magically dropped, which helps makes the shorting auto-succeed. It is straight up cheating.
Imagine a grain holding company lends you some paper 'shares' that are stand-ins for X amount of grain. It produces many of these shares, flooding the market with 'grain', and as a result the price falls. At this point their lenders buy up the grain from grain farmers at these lower prices, thus making a profit, and then return the grain to the company who then hands it out to the people who bought the shares. In this way, the grain farmers lose money because their product is devalued, while the company and its investors make money. This is the only mechanic at play: money flowing from the people who create value into the pockets of the market manipulators. Oh, and this 'grain holding company'? They never had any grain to begin with. All they had was the know-how and connections to lie and get away with it.
107% of available shares being shorted is NOT a physical impossibility. Let's say there are only 10 shares of OSTK outstanding. I own them all and make them available for borrow by short sellers. Short sellers borrow all 10 and sell them. I buy 1 of the 10 shares shorted. I lend that out too and it gets shorted. Now 110% of all issued shares have been shorted. Nothing impossible or illegal here.
This is a situation that would be EXTREMELY unusual because it's very, very dangerous for the short sellers. I could recall all my lent out shares and unless I sell one of the shares I own there is no way for the short sellers to deliver so the price will spike into the stratosphere due to a short squeeze.
The fact that short sellers were willing to short stock despite the massive short interest (which is a publicly available number) means the market as a whole believed that OSTK was wildly overpriced, which in hindsight it was.
Eh, if there is confusion at all, it isn't on my side - it's perfectly possible for there to be a sale without any merchandise.
Why does it matter that there are more shares being traded than that actually exist? It isn't about the actual trades, it's a simple contractual thing - one party promises something, the other agrees to pay for it, and as long as both end up satisfied, that's it. There is no 'merchandise being created from nothing', it's just one party promising to do something, that's it.
"e.g. more shares existing in a company means every share is less valuable"
This doesn't make sense - there are no shares created. There is a party promising to deliver shares, that's completely different.
How is "naked short selling" of stock any different from selling corn that hasn't been grown yet? Or, taking out a construction loan. etc.
There are lots of "don't have it yet" processes. Consider the typical loan. The borrower typically doesn't have the money at the time that the loan is made.
I've never got the impression that most economists think short selling distorts the market's price discovery mechanisms, and it's really dishearting that the GP is being downvoted for, plainly and clearly, stating what is economic orthodoxy.
Anyway, the futures market has functioned for centuries with people buying and selling what they don't own, and the big institutional buyers and sellers commonly use futures prices as their benchmark prices. It looks like the smart money isn't too concerned about negative effects on price discovery.
Also, let's not confuse playing by the clearly established rules of the market with "fraud". Moral objection is no excuse for equivocation.
However, with naked short selling it's a different story. When you're short selling something that you don't own you're in effect making it look like the supply is bigger than it actually is. This distorts the price discovery mechanism.
Naked short interest is almost certainly too ephermal to distort the price, but suppose it does due to illusory oversupply.
So what's the objection? If you buy, hold, and sell, you want prices to be overall lower. Selling low isn't bad if it means you were also buying low. In short, as Warren Buffet likes to point out, low prices are good for investors.
For Pete's sake, it's the rules of the game. You might have an objection to naked shorting. but you can't redefine naked shorting as "pretending" because you don't like the rules.
They're not pretending to follow the rules of the market, they are actually following the rules of the market. Having actual posession of the item at the precise moment of sale is not a rule of the market in question. Lay investors still get their shares delivered, so I have no idea what you're worrying about.
No. If someone bought all the traded shares of overstock.com at a particular point in time, they would've bought 107% of the available shares. So it would be impossible for all their shares to get delivered.
Generally, if short interest gets very high many, many professional investors get interested in buying the stock for precisely that reason. Buy enough and recall your stock, ie make it not available for borrow and you create a short squeeze sending the price into the stratosphere and then you can sell into the squeeze making a tidy profit. If you are short and your stock gets recalled you could theoretically lose your entire net worth. Something similar actually happened in Germany with Porsche trading VW stock and VW shorts getting killed during the financial crisis.
The fact that no one was willing to do that to OSTK stock tells you how shitty the company is and how overvalued the stock was.
What about when a manufacturer sells something they haven't manufactured yet under a contract to deliver a few days into the future based on a reasonable expectation that the inputs into the manufacturing process are widely available at reasonable prices and they have the technology etc necessary to manufacture what they are selling? Is just in time manufacturing fraudulent?
The risk of massive short sales are precisely to the naked short-sellers because you can be required to deliver at any time and if you fail to deliver you broker or the DTC can buy you in at any price, and charge you an enormous commission on that specific trade.
No, it hinges on entities being held to the same standard as any other contracting party in the economy. Party A agrees to do something for party B in exchange for a sum of money, party A doesn't hold up its end of the deal, now B has a claim on A for damages suffered because of A not doing what they promised.
(technically the law is more nuanced, of course - there is a whole field in law dealing with the subtleties of this, but this is what it comes down to, and it's the same whether it's for stock or grain or a wedding dress).
The solution is NOT simple. I suppose it always seems simple to impose rules on a system you don't understand.
Thousands of systems would need to change at brokers, banks, clearing firms, trade processing firms etc including mainframes running Cobol software that was written in the 70's at quasi-governmental firms like the DTC. Documentation for these systems is mainly non-existent or incorrect.
What happens now is that at the end of the day registered brokers net out all trades done by them and send files which include trade details and net trades to the DTC. On T+1, you and T+2 you figure out what would fail and why. For example, let's say Zuckerberg sells some FB. Based on FB's corporate bylaws his shares change class when he sells them so they have fewer voting rights. So when he sells them the system at his brokerage barfs because the cusip does not match the publicly traded share cusip which then leads to a cascade of fails down the line because whoever he sold it to may have sold it to someone else.
You can't just automate rules like change the class of stock if Zuck sells it because the rules are different for every company and the rules change as the board adopts new bylaws and companies change their capital structure and the systems can't change that quickly because they have to be super, super reliable. If the DTC's clearing systems go down, the US economy has a BIG PROBLEM.
About 1% of trades result in a potential failure to deliver on T+1. The vast majority of these are resolved between T+1 and T+3 so that the trade clears. Some don't. It could be something like an investor who still holds paper certificates delivering them to the broker but the courier was late etc. Resolving these fails often involves the company's registrar in addition to financial systems, for example FB's registrar would have to change the class of stock if Zuck sold his stock.
Company registrar's aren't exactly paragons of customer service. Companies generally want to hire the cheapest firm because to them it's just an added arcane expense. The registrar provides service to a back office guy at a broker, and he back office guy really doesn't have a channel to complain to the company's CFO. So the registrar generally has no incentive to provide good service and the company has no reason to fire them and change them because as far as the company is concerned it's just a expense they want to minimize and changing registrars is a huge headache.
A failure to deliver does not mean the trade is somehow cancelled. It means that either the broker or the seller needs to find stock that is good to deliver. If you go out to T+10 and there isn't a VERY GOOD DOCUMENTED reason for the fail, like a tardy registrar, the buying broker and DTC will demand deliver and buy you in if necessary, ie buy the stock in the open market and deduct your account for the cost including a generous commission for themselves. So a fail is generally a very bad thing that a seller and his broker really, really want to avoid.
Pre-2008 the rules around short selling were that if a stock was widely available for borrow, you could short it without checking. Widely available means many different owners willing to lend the stock at reasonable prices.
In 2008 in a totally made up frenzy the, same SEC which failed to stop Madoff decided to impose a new rule stating that you needed affirmative determination of a borrow before you shorted a stock. The rule makes no sense because if there were to be an event that would cause a widely available stock to suddenly become not available, you would still have fails. Remember settlement is T+3, so you would check the accounts of the people willing to lend the stock and see that they still had the stock there without realizing that it would be gone in 3 days.
The SEC subpoenaed pretty much everyone because they decided that of course the market and particularly financial stocks were going down due to naked shorting as opposed to uh'm the economy and found essentially no evidence of manipulative short selling. They brought one case against a tiny broker who made a minor paperwork error essentially unrelated to affirmative borrow other than a truly tortured link link between the two made in the SEC's press release.
Short selling is a GOOD THING. Remember in any market, the people who have the biggest influence on prices are the ones who have amassed the most capital by consistently being right. When someone who has been consistently right decides to sell a stock short, s/he is providing a very valuable service to the economy by signaling that what she's shorting is overpriced. Remember shorting is very risky. The price of a stock has no upper limit but can only go as low as 0. So when you short you can make at most the current price of the stock but lose an infinite amount. Also remember that when you short, you also have to buy the stock back at some point. There are those pesky people you borrowed the stock from who want you to return it. So on average you are selling the stock when it's overpriced and buying it back when it's underpriced and the price is under pressure. The overall mechanism creates a very valuable self correction mechanism that is absolutely essential for a healthy market. If the SEC really cared about the market's health as opposed to PR, they would be working to make shorting easier because it prevents bubbles.
Remember that the total amount of short interest in a stock is a publicly available number. If the stock of a company you are an insider of is heavily shorted and you think it's cheap and you actually believe it as opposed to want to create a huge hullabaloo, you can go out and buy it, make noise about the fact that you are buying it. If the stock is genuinely cheap or even fairly priced, you will generally create a short squeeze where shorts are forced to buy back quickly as the stock shoots up in their face. OSTK insiders did not do that.
I don't actually know of a single instance where an insider or corporate inside has complained about a short seller shorting their stock and pushing the price down where there actually weren't genuine problems with the company. Remember it often takes 2-3 years for the whole story to come out and by then the media may not want to acknowledge that they breathlessly repeated every bit of tripe the CEO said about the evil, faceless short sellers. Usually a CEO complaining or a company filing a lawsuit against a short seller is a very high probability sign that the company is in genuine trouble because otherwise you would see insiders backing up the truck to buy the stock.
I find it truly amazing that the press and from the comments even the supposedly informed set at Hacker News would get worked up about this when it's about OSTK, Overstock.com. They sued people for shorting the stock and driving the price down for 60 dollars a share!! by making negative statements about the company that weren't true. With the benefit of hindsight it's clear that pretty much everything negative publicly said about OSTK was not just true but probably too optimistic, and the management has been lying which is felony under US law. Yet the SEC refuses to prosecute the management which is who is truly responsible for fleecing gullible retail investors.
It's truly astounding that OSTK is now choosing to go after GS based on snippets of emails etc which sound bad if you don't understand financial terminology and also don't have context but really aren't anything particularly bad, unless of course you let Tabibi self-aggrandize himself by claiming he understands stuff he has absolutely no clue about.
Fortunately the solution is quite simple. Force short sellers to make the shares available instantly at the time of the short. They could be held in escrow by the exchange until settlement either way. Go go gadget SEC?