Failures To Deliver - Stock Price Arbitrage

If any issue most concerns penny stock investors, it has to be failures to deliver. When a broker in the commercial banking sector sells innumerable stock without first buying them and then not settling the account over an extended period, you get failures to deliver. This is more colloquially known as 'naked shorting.'

Someone will come in and buy a certain amount of stock and hold them for longer than 55 days.(limit set in the DTCC) At some point, they will want to sell, or the stock rises above the point at which stocks were naked shorted. The same broker who first sold stocks without owning them is obliged to buy all of them back, because they would be facing immediate losses.

Often times, they merely roll over the account for an extended period, assuming that their naked short is correct, and that the stock will fail, or fall below a certain point. If the buyers then sell, there is no longer any failure to deliver and the problem goes away. If the buyers continue to assume downside risk, then naked shorting a stock becomes problematic, because failures to deliver can pile up over very long periods.

For the most part, brokers use 10X leverage. So any naked shorting effort is likely to be 10X leveraged as well, since the downside of a few cents is highly profitable. In order to close, you need to bid to cover, and this requires capital. Profits are generated when the difference between the bid to cover and the original leveraged capital outlay.

But the game is more complicated in that it depends on interest rates and short term money markets. But if the stock rises, you are required to cover your naked shorting as the bid to cover exceeds your capital outlay. You can double down on your bet if you have leverage. This is why GBN.V stock can trade in the hundreds of thousands of shares on any given day and not rise. A change in interest rates can make your bid to cover problematic, because your ability to turn over the contract is impaired. Thus trading in the stock becomes like passing a hot potato around.

By way of example, the following article had an interesting comment and a very curious list of failures to deliver on the pink sheets, which are actually listed penny stock miners:

“This is purely arb activity, the house that short sells effectively earns the management fee for the period they fail, we are talking tiny profits but this is what the HFT guys rely on, they hedge for virtually zero cost, earn the fees for a week or 2 being naked short then buy it back for zero cost, if you can roll these positions over it is like being an ETF provider without all those nasty setup and admin costs”