Weekend deep dive--revisiting Talis Putnis' 2009 article Naked Short Sales and Fails to Deliver An Overview of Clearing and Settlement Procedures for Stock Trades in the US

"The US clearing and settlement system does not provide any significant disincentives for naked short selling."

Happy weekend Superstonk! I hope everyone is able to enjoy the long weekend with loved ones and remembering those who make it possible for us to be doing so.

However, if you have some down time and would like some weekend reading, Talis Putnis with the Stockholm School of Economics has the following to say about naked shorts.

Source: https://www.researchgate.net/publication/228260887_Naked_Short_Sales_and_Fails_to_Deliver_An_Overview_of_Clearing_and_Settlement_Procedures_for_Stock_Trades_in_the_US

Just from the abstract this sounds good!

This article outlines the process of clearing and settlement for stock trades in the US. It pays particular attention to what happens when the seller of a stock fails to deliver that stock at settlement and describes the mechanisms to resolve delivery failures. Fails to deliver can occur for a number of reasons, such as human error, administrative delays and the controversial practice of naked short selling. This article helps understand the implications of naked short selling for trade counterparties and, more generally, the effects of naked short selling on the clearing and settlement system.

Keywords: clearing, settlement, fail to deliver, naked short selling, National Securities Clearing Corporation (NSCC), Depository Trust Company (DTC).

Introduction:

"Naked short selling, i.e., selling a stock short without borrowing it and subsequently failing to deliver the stock at settlement, has recently caused much sensation."

• "Critics claim that naked short selling is used in abusive trading strategies and manipulative attacks on companies."
• "Disgruntled Wall Street veterans, company directors and shareholders have blamed naked short sellers for the collapses or near collapses of several companies and gone so far as to establish organizations to campaign against naked short selling (e.g., National Coalition Against Naked Shorting (NCANS))."
• "Regulators such as the US Securities and Exchange Commission have responded with a frenzy of additional rules and temporary bans, on several occasions stating their concerns about naked short selling."
• "Despite the widespread criticism, not all naked short selling is abusive."

"Some naked short selling occurs unintentionally when a short seller, in line with current regulation, locates shares to borrow (or has reasonable belief that shares can be located and borrowed), but for some reason is unable to borrow the stock in time for delivery."

• "Further, some naked short selling is due to market making."

"A fail to deliver (FTD) occurs when the seller of a security does not deliver that security to the buyer within the standard three-day settlement period."

• "Naked short selling is one way that this can occur."
• "FTDs can also arise from various processing errors, delays in obtaining physical stock certificates or human error in entering the incorrect stock symbol."

"Figure 1 plots the aggregate number of FTDs and daily trade volume for stocks listed on the New York Stock Exchange, the American Stock Exchange and Nasdaq from 2004 to 2009."

• "As one might expect, the number of FTDs is correlated with overall trade volume, but also exhibits some meaningful deviations."
• "Fail volume decreases between 2004 and 2007, increases rapidly during 2007 and 2008 and declines substantially at the end of 2008."
• "For most of the period between 2004 and 2009 the number of FTDs for stocks listed on the main US exchanges is between 1.5% and 5% of average daily trade volume."

The purpose of this article is to provide an overview of the clearing and settlement procedures for stock trades in the US, with a focus on what happens when market participants fail to deliver stock at settlement. This information helps understand the implications of naked short selling for trade counterparties and, more generally, the effects of naked short selling on the clearing and settlement system. First this article highlights the differences between naked short selling and traditional short selling. Next it describes: (i) the organizations involved in clearing and settlement; (ii) the procedures for trades that settle successfully and trades in which the seller fails to deliver stock at settlement; and (iii) the mechanisms to reduce FTDs once they occur. Finally, this article draws some conclusions about the clearing and settlement procedures in relation to delivery failures.

TRADITIONAL VS NAKED SHORT SELLING:

Because naked short sellers do not borrow the stock they can theoretically sell an unlimited volume of stock into the market, driving down a share price:

Two possible reasons for intentionally engaging in naked short selling are:

• (i) to short sell stocks that are difficult or impossible to borrow; and

(ii) to conduct manipulative “bear-raids” on stocks. When borrowing costs are high, market makers sometimes choose not to borrow and instead naked short sell.

• In such cases naked short selling, then failing to deliver is economically equivalent to borrowing shares at a zero-fee zero-rebate equity loan plus the expected cost of being forced to buy back the stock and deliver it (a process called “buying-in”).
• In difficult-to-borrow stocks, this amount can be less than the cost of borrowing.

Critics of naked short selling, and many companies that claim to have been targets of manipulative selling attacks argue that naked short selling can be used to conduct “bear-raids” because naked short sales artificially increase the supply of shares in the market.

• Because naked short sellers do not borrow the stock they can theoretically sell an unlimited volume of stock into the market, driving down a share price.
• Traditional short sellers, on the other hand, are limited by the amount of stock they can locate to borrow, which can become limiting as the level of short interest becomes large.

ORGANIZATIONS INVOLVED IN CLEARING AND SETTLEMENT:

"Through its subsidiaries, the Depository Trust and Clearing Corporation (DTCC) provides clearing, settlement and information services for equities and other securities traded on US financial markets."

• "One of its key roles is to reduce counterparty risk by guaranteeing obligations will be fulfilled."
• "It centralizes, automates, and standardizes the clearing and settlement processes."
• "Two DTCC subsidiaries that play important roles in these processes are the National Securities Clearing Corporation (NSCC) and the Depository Trust Company (DTC)."

"The NSCC fulfills the clearing role (computation of the obligations to be settled) and serves as the central counterparty for trades in the US securities markets."

• "In doing so, the NSCC guarantees completion for virtually all broker-to-broker trades involving equities."
• "In its clearing role, the NSCC is responsible for multilateral netting of trades and payments among its participants, thereby reducing the number of payments and securities that are exchanged."
• "This function also serves to reduce counterparty risk."
• "Trades are netted in the Continuous Net Settlement (CNS) system."
• "The NSCC has roughly 4,000 participants and is regulated by the SEC."

"The DTC, in fulfilling its role facilitating settlement (the actual transfer of securities and cash between buyers and sellers), maintains a centralized store of stock ownership records."

• "Today these are largely electronic records (although the DTC is also a store of physical certificates) and cover a large proportion of all US listed stocks."
• "The DTC is responsible for transferring stock ownership, usually by making electronic book-entry changes, to reflect NSCC's net settlements (or instructions from other trade matching services or participants), as well as transferring money between participants (brokers and broker-dealers)."
• "The DTC does this by debiting and crediting participants’ securities and money settlement accounts held at the DTC."
• "The DTC is registered as a clearing agency with the SEC and monitors its participants to ensure compliance with DTC’s Rules and Procedures. The SEC conducts an annual inspection of DTC’s data processing areas and has conducted an inspection of selected operating areas every other year."

"If a participant fails to settle with the DTC, the DTC may cease to act for that participant and terminate their membership."

• "Such events are notified immediately to the SEC via a filing and to other clearing agencies via DTC’s Participant Terminal System (PTS)."
• "The participant is expected to continue to meet all its settlement obligations."
• "The DTC has resources, consisting of an all-cash Participants Fund (collateral deposited by participants) and a committed bank line of credit, in order to complete settlement and cover any losses from participants’ failure to settle."
• "The NSCC also has a Participant Fund that it holds as collateral to cover losses from participant defaults. This serves as a form of mutualized default risk-sharing."

Clearing participants include brokers, broker-dealers, banks and insurance and investment companies.

• They are bound by the rules of the NSCC and DTC and pay fees to the clearing organizations, which participants in turn may pass on to their clients.
• Figure 2 illustrates simplified interactions between key parties in a typical stock transaction.

What happens when a fail occurs?

If a participant is unable to deliver on their net short position (stock owed to the NSCC), the position is called a “fail to deliver” (FTD) and the short position remains open.

• The failure to deliver may be because the seller does not own the stock or simply because of an administrative delay in obtaining the stock ownership records, for example, when physical certificates have to be found.

When participants fail to deliver stock, the NSCC receives less stock than it owes and consequently may not be able to deliver stock to all participants with long positions.

• The long positions for which the NSCC is unable to deliver stock remain open long positions called “fail to receive” (FTR).
• This can be thought of as an IOU from the NSCC to the participant with the long position and similarly the FTD can be thought of as an IOU from the participant with the short position to the NSCC. Dividends are automatically debited from participants with FTD positions and credited to those with FTR positions.
• However shareholder voting rights are distorted because FTR holders (participants with stock IOUs from the NSCC) do not receive the usual voting rights that they would had the stock been delivered. They are also unable to lend the stock until they actually receive it.

Critics of the NSCC claim that a potential danger of this system of marking to-market the cash collateral is that in the case of fails caused by naked short sellers conducting “bear raids”, as the price of the stock falls, the naked short seller is able to withdraw the cash adjustments and leave the NSCC heavily under-collateralized for the true value of the stock. However, this is not possible because the level of collateral held by the NSCC cannot decrease when prices fall, it can only increase when prices rise.

The Stock Borrow Program:

• A mechanism the NSCC has in place to reduce the number of FTRs (but does not reduce FTDs) is the Stock Borrow Program.
• Under this program participants are able to lend excess stock in their DTC accounts to the NSCC so that the NSCC can satisfy delivery requirements not filled via normal deliveries.

Each day, participants submit a list of stocks they own that they would like to have participate in the Stock Borrow Program.

• Once the NSCC determines the open long positions (stock it owes participants) that are due to become FTRs, it attempts to satisfy these obligations by borrowing from participants in the Stock Borrow Program.
• If there are more potential lenders than the NSCC’s borrowing requirement, the NSCC determines which lenders it will borrow from using an algorithm that takes into account participants’ average loans and clearing fees.

Although the NSCC states that the purpose of the Stock Borrow Program is to cover temporary shortfalls in CNS, there is no time limit on how long NSCC may borrow stock from its participants.

In the remaining approximately 80% of cases the FTRs persist in perpetuity and are passed on from one participant to another as stocks are traded.

For FTDs caused by naked short selling, the situation resulting from the Stock Borrow Program is equivalent to the naked short seller borrowing stock from the Stock Borrow Program participants at a zero-fee zero-rebate loan and sort selling the stock to the participants that would have received FTRs in the absence of the Stock Borrow Program. The Stock Borrow Program has been criticized for allowing naked short selling to persist.

If a naked short seller is forced to buy-in, then in order to maintain a short position they must buy the stock, deliver it to the initial counterparty and then naked short sell the stock again, together costing them the roundtrip transaction costs. The NSCC may also charge a fee to the participant that fails to deliver, however, the fee is insignificant in relative terms. Because the incidence of buy-ins is low and penalties for failing are small, naked short selling effectively is a way of short selling difficult or impossible to borrow stocks.

TLDRS:

Talis outlined the process of clearing and settlement for stock trades in the US.

• It has paid particular attention to what happens when the seller of a stock fails to deliver at settlement and has described the main mechanisms in place to resolve delivery failures.

From a naked short seller’s perspective, naked short selling is economically equivalent to a zero-fee zero rebate loan to the naked short seller from a participant that involuntarily fails to receive shares.

1. The algorithm that allocates shares to participants after multilateral netting passes existing FTRs to participants with more recent long positions.
2. Therefore, the participants that effectively act as involuntary stock “lenders” in this arrangement change as shares are traded.
3. When the Stock Borrow Program resolves a naked short seller’s FTD, the situation that arises is economically equivalent to a zero fee zero-rebate loan from the Stock Borrow Program participant to the naked short seller.

From the buyer’s perspective, buying from a naked short seller does not necessarily result in failing to receive the stock at settlement.

1. The algorithm that allocates shares is equally likely to allocate the resultant FTR to any of the other participants that bought the same stock on the same day (assuming normal priorities).
2. This further suggests that a buyer may fail to receive shares at settlement even though the seller delivered the shares at settlement.
3. Buyers that receive an FTR during settlement rather than the actual shares are unlikely to be aware of this.
4. They have most of the rights of buyers that receive shares during settlement (e.g., entitlement to dividend payments and right to sell the stock), but not all of the rights (e.g., no voting rights and no entitlement to lend the stock).

This overview suggests an alternative to the reason put forward by Boni (2006) to explain why buy-ins are rare.

1. Given the way in which the settlement procedures reallocate FTRs and the finding that FTDs represent approximately 1-5% of daily traded volume, only in rare circumstances or in very infrequently traded stocks would a participant have an FTR for long enough to initiate the Buy-in process, let alone complete it.
2. Further, if a buy-in is completed, the participant forced to purchase the stock is not necessarily the same participant with which the Buy-In Notice originator traded.

The US clearing and settlement system does not provide any significant disincentives for naked short selling.

1. The Buy-in procedure, on the rare occasions that it is used, is unlikely to force a naked short seller to close out the FTD;
2. The Stock Borrow Program effectively facilitates a zero-fee zero-rebate loan to the naked short seller;
3. The fees for failing are insignificant.

Reddit Post