SEC Trips at Finish Line; Fraud Wins

David Patch

July 18, 2008

At the present time the SEC was in the process of engaging in unprecedented steps to insure that naked short selling does not damage the confidence of the banking industry and thus add additional burdens to our already fragile US Economy. The SEC had created an emergency order that was focused on preventing the abuses of naked short selling in the trading of our banking institutions by enforcing a pre-borrow requirement on all short sales executed.

In an editorial column published in Investors Business Daily SEC Chairman Chris Cox stated:

“Naked short selling can turbocharge these "distort and short" schemes. In a naked short, the usual process of short selling is circumvented, because the seller doesn't actually borrow the stock and simply fails to deliver it. For this reason, naked shorting can occur even when actual shares aren't available in the market. It allows manipulators to force prices down without regard to supply and demand.

Next week, the SEC will implement an emergency order designed to prevent naked short selling in the financial firms that the Federal Reserve Board has designated as eligible for access to its liquidity facilities. “

And for a moment there it appeared that the sleeping regulator had suddenly awoke and was ready to cross that finish line first.

Then we awoke and found that it was just a dream, that the SEC really did not put a stop gap to fraud but instead welcomes it with open arms.

According to reports, the industry market makers and Options Market Makers (OMM) have lobbied the SEC’s Division of Trading and Markets to provide them with exemption from the short sale pre-borrow rule about to be required of 19 publicly trading banks and institutions. The staff is considering such exemption and will propose it to the Commission.

According to SEC spokesman John Nester the proposed change would exempt market makers in the 19 stocks and their derivatives from needing to borrow shares in advance of short sales "in their market-making and related hedging activities" in the stocks.

Okay, so let me get this straight, naked shorting is bad and can be used by manipulators to drive a market down and yet, in a free falling market the market makers need to be granted authority to naked short for liquidity? Doesn’t the general principle of a free falling market imply that there is more than sufficient sell side liquidity?

Most likely it will be James Brigagliano, Associate Director for Trading Practices and Processing that will be assessing whether the exemptions should be provided. Brigagliano, for those who don’t know of him, is the very individual who led the Committee’s in the concept of Regulation SHO, was present in the private meetings where the Securities industry and Financial Markets Association (SIFMA) proposed the ill-fated grandfather clause that was a last minute addition to the SHO release, was the Committee lead on the team that removed the uptick rule from our markets, and has been the Committee lead on the elimination of the Options market making exemption which is on it’s third year of public comment.

To say that Brigagliano doesn’t get it and has been captured by industry lobbyists would be an understatement and what comes next will prove it.

Consider, in June 2008 the SEC’s Office of Economic Analysis reported on a study they had conducted regarding the rise in settlement failures in our capital markets. In January 2005 the aggregate level of fails on a daily basis were valued at near $3.4 Billion. In March of 2008, some three years after regulation SHO was implemented to reduce fails to deliver, the aggregate level of fails to deliver on a daily basis were valued at near $8 Billion. Unsettled trades (naked shorts) had near tripled during a period when the SEC was focused on eliminating fails altogether.

The analysis published states that “one explanation of these results is that the investors who previously failed to deliver in the equity market have now moved to the options market to establish a synthetic position. Since the option market makers still enjoy an exception to the close-out rule and tend to hedge their positions in the equity markets, the fails may now be coming from the option market makers instead of the equity investors themselves.”

That’s right, short sellers moved their intentions over to the options market and used the options market maker as a third party participant in the naked short of the underlying equity. All that was required was to overwhelm the Put market and drive the OMM to hedge their book by naked shorting the underlying equity.

The question for Mr. Brigagliano would be, does the equity market and pricing efficiencies in that market know to differentiate between a naked short executed as a hedge on a Put contract from a naked short that previously was dumped directly into that market by the hedge fund? Should a synthetic position be afforded the luxury of impacting the pricing efficiencies of a real share in the equity market?

Unfortunately the SEC would like us all to think that this June 2008 analysis was new and that they are just coming to studies that expose how and why naked shorts exist. But we know better and we refer back to 2004 when then SEC Fellow Lesli Boni drafted a white paper called “Strategic Fails to Deliver in the US Equity Markets.”

This white paper was used as part of the creation of Reg SHO and outlines how short sellers were using the lower cost approach of the options market to strategically obtain short positions without the expense of a borrow fee. This approach was not only cost effective but created the same equity market pressures that an equity short or naked short would have because the OMM would make that trade for them as a hedge to the Put contract.

Boni writes “We argue that long-lived (“persistent”) fails are more likely the result of strategic fails rather than inadvertent delivery delays. Consistent with the hypothesis that pre-Regulation SHO, equity and options market makers strategically failed to deliver shares that were expensive or impossible to borrow, we find some evidence that these long-lived fails were more likely to occur when stocks were expensive to borrow, as proxied by institutional ownership, book-to-market, and market cap.”

So it is a cost game where, when James Brigagliano backs down to the lobby of the industry and the Commission signs off on this they will have done so not for market stability and safety but for revenues. When expense and profits are undermined by market safety, expense and profits will win out each and every time.

As I conclude on this disturbing development I ask a few simple questions:

1. If market makers are provided this exemption to create liquidity in offsetting excessive interests in a singular direction, and the SEC will again be providing market makers with naked shorting allowances in this free falling market for liquidity sake, where were the market makers in providing the buy side liquidity to hold back the free fall? How was it that the reason for the free fall was due to a lack of buy side interest and apparently market making purchased to keep the stock price stabilized while the sell side was heavily overburdened.

2. If the SEC allows both market makers and options market makers to use this exemption, won’t that make it difficult to weed out the good from the bad? Clearly the SEC will not be able to distinguish real time what the fails to deliver are being attributed to when there will continue to be an allowance for unlimited failed trades in these 19 securities?

3. How does the SEC plan on addressing the hedge funds use of the options market maker to manipulate the equity market? Were the floodgates not re-opened here?

One thing is for sure, this false start by the SEC and their ability to trip at the finish line has certainly made it easier for the market professional manipulators to win this race. We can also rest assured that despite the near 1000 comment memo’s already published supporting the full elimination of the OMM exemption under SEC proposed rule 34-58107 the SEC will not be supporting public opinion. The SEC has tipped their hand here. If the SEC can’t eliminate this exemption for the 2 week period this emergency order covers how can we ever expect them to eliminate it permanently.

Finally, from the archives of the SEC where we are informed that each of these market makers have alternatives to carte blanche naked shorting but choose to ignore the alternatives comes this memo:

“On December 19, 2006, members from the Division of Market Regulation met with Matthew F. Andersen, John C. Nagel, Daniel Dufresne, Adam C. Cooper, Mathew Hinerfeld of Citadel Investment Group, L.L.C. to discuss the proposed Commission amendments to Regulation SHO. Citadel stated that it rarely uses the grandfather and options market maker exceptions to Regulation SHO because it has implemented procedures to close out fail positions prior to the 13th consecutive settlement day. Therefore, Citadel had no comments on the proposed amendments. “

Citadel just happens to be one of the largest volume options market makers in the marketplace and they don’t need the exemption to operate their business profitably.