|
Article Excerpt
In 1985, the National Association of Securities Dealers (NASD) commissioned Irving M. Pollack, a securities law expert and former Securities and Exchange commissioner, to conduct a comprehensive review of short selling in NASDAQ securities. The NASD sought to determine what, if any, additional short selling regulation was needed for the NASDAQ market. The result was the now-famous "Pollack Study," which described the short selling landscape of the day and made important recommendations regarding the disclosure, reporting, and settlement of short sales.
Pollack concluded that short selling was a vital source of liquidity and a valuable mechanism for efficient price discovery. He added, however, that without proper institutions to guarantee prompt clearance and settlement of short sales, short selling was open to abuse. Of the settlement regime, he cautioned that it "effectively insulates the clearing corporation and brokers from fails to deliver and receive by contra-parties; but it permits fails to deliver and receive to develop without an automatic check." He issued a sober warning:
The fail-to-deliver/fail-to-receive problem has the potential for causing serious difficulties in a lengthy bear market. While the evidence does not suggest that delivery problems exist in many securities, the fact that there is no automatic mechanism preventing the substantial buildup of short positions at the clearing corporation and of fails to receive in brokerage firms carries the potential for serious problems, particularly in the event of crisis market conditions.
The phrase "short positions at the clearing corporation" refers to "failures to deliver" (FTDS), which effectively increase the net supply of an issue in circulation and, by definition, depress price. This price depression is, of course, more significant for small and medium cap companies than for large cap companies with greater liquidity.
There is currently much controversy surrounding so-called "naked short selling," about which Pollack also warned over two decades ago. Some companies, investors, and academics see naked short selling and the delivery failures that can result as harmful (and illegal) wealth destruction mechanisms. Skeptics claim that naked short selling, as an issue, is buoyed only by poor-performing companies and investors seeking a scapegoat for stock price declines.
Unfortunately, the drama associated with this clash has drawn attention away from the uncomfortable fact that illegal, unsettled trades are a large and growing problem in U.S. equity markets. Those unsettled trades threaten the corporate voting system, the viability of small companies, and market integrity as a whole. Large unsettled trades persist because of loopholes in stock market institutions and apathy on the part of those charged with enforcing existing regulations.
[ILLUSTRATION OMITTED]
DEMATERIALIZATION AND SECURITIES ENTITLEMENTS
Physical stock certificates are an anachronism in modern stock markets. Today, stock ownership changes are reflected in electronic book-entry movements among broker-dealers' accounts at the Depository Trust Company (DTC), a central stock depository and member of the Federal Reserve System. The DTC acts as a custodian for the majority of securities issues. The DTC emerged in response to the "paper crisis" of the 1960s, when stock transfer volume in the United States grew so large that issuers, transfer agents, exchanges, and brokerages were unable to process efficiently the paperwork associated with stock trades. The marketplace was overwhelmed by paper and timely transfer became impossible. The securities industry created the DTC in order to make stock transfer efficient and orderly.
The DTC modernized markets through "dematerialization": the transition from physical stock certificates to electronic bookkeeping. With dematerialization came major revisions to the Uniform Commercial Code in 1977, and later in 1994. Those revisions introduced "security entitlements" to our markets, which took the place of direct share ownership. Strictly defined, a security entitlement "guarantees an entitlement holder a priority in the financial assets held in [an] account over the securities intermediary or the security intermediary's creditors."
Today, investors trade in securities entitlements while physical certificates are held in "fungible bulk" at the DTC. As Erik Sirri, director of the SEC's Division of Trading and Markets, explained at a 2007 symposium on proxy processing:
Broker participants in DTC own a pro rata interest in the aggregate number of shares of an issue held by DTC. And their beneficial owners, the end customer, owns an interest in the shares in which the brokers, themselves, have an interest. Consequently, there are no specific shares directly owned by either broker participants, DTC, or the underlying beneficial owner. As a result, the beneficial owner's ownership cannot be tracked to a specific share, but rather, his ownership interest is represented as a securities entitlement at his or her own broker dealer. Each of these beneficial owners don't own the actual shares that have been credited to their account, but rather, they own a bundle of rights defined by Federal and State law and by their contract with the broker.
That bundle of rights is represented by security entitlements in investor brokerage statements. Most investors, however, believe that a security entitlement is an electronic claim of ownership on a given number of shares of an issue. That belief is incorrect.
The DTC is a subsidiary of the Depository Trust and Clearing Corporation (DTCC), which acts as a central counterparty for U.S. exchanges and markets for equities, bonds, U.S. Government treasuries, and other securities. The DTCC manages the clearance and settlement system for U.S. equities through its subsidiary, the National Securities Clearing Corporation (NSCC). While physical payment and stock transfer occur within the DTC, it is the NSCC that provides final settlement instructions to customers and participant firms.
FALLS TO DELIVER
Short selling is a bet that a stock price will decline. A short seller borrows stock and then sells it, hoping to buy back the same amount of stock later, at a lower price, for return to the lender. Though sometimes controversial, short selling is a legal and vital source of liquidity and efficient price discovery. Executing short sales without borrowing or delivering shares, however, can lead to delivery failures.
Naked short selling involves selling without first borrowing stock (or even locating stock to borrow). If a naked short seller does not borrow the stock he sells, he will be unable to deliver that stock to the buyer to settle the trade. Intentional naked short selling is illegal, though market makers are currently allowed to naked short temporarily when engaged in bona fide market making. (Even market maker FTDs, however, are illegal when delivery failure exceeds 13 days.)
In U.S. equity markets, settlement occurs within three days of a trade. In the case of both long and short sales, if shares are unavailable for delivery then the settlement process can be complicated by FTDS and "failures to receive" (FTRS). To the extent that FTDs and FTRs are only occasional and temporary, trade in security entitlements rather than physical shares helps to keep markets liquid...
|
