Category Archives: short selling

What caused the “Crash of 2:45”?

May 11, 2010 By in Current Market Thoughts, ETFs Vs. Mutual Funds, hedge funds, Portfolio management, Recent Market Action, short selling, Trading, uptick rule Tags: , , , , , , , Leave a comment

The short answer is that anyone who knows the details isn’t telling.

what happened

Last Thursday, May 6th, was a generally bad day on Wall Street.  What makes this session worthy of not, however, is the Tower of Terror-like plunge that the market took at about 2:45 pm, followed by an equally swift rebound several minutes later.

visiting the SEC

Representatives of the major exchanges met with the SEC yesterday to discuss the situation.  All reportedly professed to have no idea what caused the sudden decline and rebound.  That’s not really much of a surprise.  On the one hand, no one wants to take the risk of becoming Congress’s latest whipping boy if they admit to having had even an innocent hand in the debacle.  On the other, its track record in cases like Madoff suggest that the SEC doesn’t have the knowledge or interest to pursue the issue by itself.  So anyone involved would likely be calculating that, absent a public declaration of repsonsibility, they will never be found out.

rumors

There have been two persistent stories about the trigger for the mid-afternoon drop.  One, offered by CNBC, is that a trader from Citigroup made an input error that generated a sell order that was 1000x the amount intended.  Citi denies this.  The second, more detailed–and therefore, I think, initially more plausible–comes from the Wall Street Journal. According to the newspaper, the initial trigger was a relatively small sell order placed in the Chicago options market by hedge fund Universa Investments.   However, the Journal may have been attracted to this trade as much by the fact that Universa is linked to Nassim Taleb, who popularized the idea that disruptive “black swan” events are much more numerous than academic theories allow for.

what we do know

Several things are clear:

–as the computer-to-computer selling got more intense, the NYSE turned its machines off and reverted to manual processing of trades.  Apparently, although I wasn’t aware that this was the case, this is the NYSE’s publicly stated policy.  This action effectively eliminated one of the main ways derivative holders could hedge their positions with offsetting exposure in physical stocks.  It caused trades to be redirected to other middlemen, who buckled under the added pressure.  It isn’t clear whether the others took defensive measures similar to the NYSE’s or whether they were simply overwhelmed by volume.

–ETFs were hurt unusually badly in the selloff.  According to the Financial Times, two-thirds of the securities where exchanges subsequently cancelled trades were ETFs.  ETFs themselves represent only about 16% of the total number of securities traded on US exchanges.  I don’t think there’s any great significance to this, however.  In a “normal” stock trade, the market makers matches a third-party buyer and seller–who have already decided they want to transact–and charges a bid-asked spread.  In an ETF trade, however, the counterparty is often the market maker himself, who is constantly calculating the NASV of the underlying ETF and his hedging possibilities and deciding whether to transact at a given price or not.  To let the market know he is potentially a buyer or seller, he typically has “placeholder” bids of, say, $.01, that under normal circumstances let the world know that he may be interested in transacting.

Last Thursday, a lot of those $.01 bids were hit before the market makers could withdraw them.

–as mentioned above, the exchanges unilaterally decided to cancel transactions they considered to be anomalies.  This presumably leaves a lot of unhappy individuals who had placed low-ball limit orders.  Perhaps not by coincidence, the counterparties–that is, the losing side–to those canceled trades are the same exchange members who canceled them.

what happens next

The SEC is under political pressure to do something to prevent a recurrence of anything like the near-instantaneous decline of 5% that happened last Thursday.  Some of this pressure likely comes from proponents of having a stronger “uptick rule” (see my post on this topic).  Although the current uptick rule seems to me to invite sudden plunges in stock prices of the type we had last week, no one is publicly suggesting that this is the cause of last Thursday’s meltdown.

Whether needed or not, a new trading halt mechanism is probably the “solution” the SEC will opt for.

I have two related thoughts:

–added volatility may just be a fact of life in a modern stock market, where computer-to-computer trading and monthly performance measurement of the type hedge funds undergo are prevalent.  In other words, get used to this.

–the first time something like this happens, it’s a surprise.  Even now, I’m sure that investors are beginning to devise strategies to cope with–and take advantage of–increased volatility.  Understanding what’s going on and planning for it, investors will enter the market as buyers sooner and more aggressively. By doing so, they will temper volatility.  For their part, sellers, learning that there’s a penalty for being aggressive on the downside, will adjust their behavior as well.

That’s why I think canceling money-losing trades made by people pushing the market down is a really bad idea.

–no one so far is questioning the behavior of the NYSE (admittedly, not my favorite organization).  It’s kind of like switching from big fire hoses to small ones as soon as the fire starts.  What good is that?  In fact, if this incident isn’t the accident that I think it was, short-sellers may have been counting on the NYSE to remove liquidity from the market.

“naked” short sales

February 28, 2010 By in "naked" short selling, short selling, Trading Tags: , , , , , , Leave a comment

Settling a trade

Every stock market in the world has procedures for how a trade is settled, that is, where and when the buyer brings his cash, the seller his stock and the two complete the bargain entered into when the trade was agreed to.   In the case of the US, this usually occurs three days after the bargain is struck.

Curing a failed trade

Every stock market also has standard procedures to deal with a trade that “fails,” that is, cases where the deal isn’t completed, because one party or the other doesn’t show up or brings the wrong amount of money or the wrong amount of stock.

Penalty fees may be involved.  And, if the seller can’t deliver the stock he has promised to the buyer after a reasonable (but short) amount of time, the broker typically is authorized (and legally required) to buy the agreed-upon shares in the open market, deliver them to the buyer from the original trade, and send a bill to the seller.

“naked” shorts

This brings us to “naked” short sellers.   Before the short seller enters his “sell” order, he is supposed to have good reason to believe he can deliver the required stock on settlement day.   As I mentioned in my first post on short selling, there is an elaborate infrastructure in the US devoted to stock lending, the process of making stocks available for short sellers to borrow.  So the short seller should have a very good idea whether borrowing a given stock is possible or not, and how long it will take to get the stock into his hands.

A short seller who pretty much knows he can’t borrow a given stock, or has no intention of borrowing the stock, but sells it short anyway is called a “naked” short seller. Generally speaking, except for market makers providing temporary liquidity to a market, the practice is illegal. Until the past few years the rules weren’t enforced, so naked shorting occurred anyway.  In the best of circumstances, the buyer ended up being an uncompensated lender to the short seller, who was avoiding posting collateral and paying fees to a stock lender.  At worst, the short seller was trying to manipulate the market in a given stock.

market makers vs. hedge funds

I think it’s important to distinguish here between the activities of market makers in a given stock and those of professional investment managers, like hedge fund operators, who may sell a variety of stocks short.  Both may be “naked” short sellers.  But their activities are very different.

A market maker who sees an imbalance of buyers over sellers in one of his stocks may provide liquidity to the market by shorting shares to buyers.  His intention is to buy the shares back quickly himself to reestablish a neutral position, not to borrow the stock from a third party (and pay fees).  Clearly, the market maker intends to make money from his shorting activity, but one can reasonably argue that his actions have a stabilizing function.

This is very different, I think, from the actions of a professional investment manager, who from the outset doesn’t intend to honor the bargain he makes with a buyer.  He depends instead on the rules against naked shorting not being enforced so that he can evade his contractual obligation for as long as possible.

His actions are basically destabilizing, since he is overriding one of the basic safety features of any market that allows short selling–the requirement that you can only sell stock you have an ownership right to.

Why is this distinction important?–because advocates of naked shorting seem to me to deliberately muddy the waters by citing the benefits of shorting by market makers as a defense for the destabilizing actions of some professional money managers.

What’s wrong with naked shorting, in my opinion

1.  The regulatory requirement that a short seller be able to settle his trades is a reasonable one.

–It ensures that the buyer is able to profit if his “buy” decision is correct, instead of winding up with a failed trade and a stock that has run away from him.

–It also eliminates the possibility of bogus transactions by short sellers who can’t borrow stock, or who don’t want to post collateral or pay fees, yet who want to defend their short positions by impeding the upward movement of the stock.

2.  The need to borrow shares sets a natural limit (the number of shares outstanding) on how how many shares of a company’s stock can be shorted.  In practice, the limit to shorting is actually lower–the number of shares that holders are willing to lend.  The ability to create phantom shares through naked shorting tilts the playing field sharply in favor of short sellers.

3.  From a tactical point of view, holders of a stock have two defenses against short sellers, both of which are neutralized by naked shorting.  They are:

–Owners can call back the stock their organizations have lent to short sellers, forcing the latter either to find shares to borrow elsewhere or go into the market and “cover” (buy back the stock) their short positions.  Or,

–holders themselves can enter the market as buyers and try to support the current price by absorbing all the stock for sale, and potentially drive the price higher.

Either tactic can create a “short squeeze,” that is, a self-perpetuating scramble of short sellers to cover their short positions that, like a snowball rolling downhill, pushed the stock price considerably higher.  However, naked shorting removes these risk elements for short sellers.

You can’t call back stock that has never been lent and exists only in the imaginations of the short seller and his broker.  You also can’t dry up  the pool of sellers if they can “manufacture” new stock to short out of thin air.

A problem until 2005

That’s when the SEC instituted Regulation SHO, which makes brokers to follow rules that were already on the books.  In particular, it requires brokers to:

–document that borrowed stock is available to settle a trade before the bargain is struck, and

–“close out” a trade that has failed for 13 consecutive trading days by buying in the securities and delivering them to the original buyer.  The close out rule only applies, however, to stocks that exceed specified levels of failed trades.

In the link to the SEC website above, the agency is at great pains to point out that it does not regulate “pink sheet” stocks, seemingly implying that naked shorting is common there, even today.

There’s also academic research demonstrating that manipulative naked shorting was prevalent until Regulation SHO, after which it has substantially disappeared.  Oddly enough, I first became aware of this paper by reading commentary in Barron’s that made fun of SEC concern about naked shorting of Bear Stearns and Lehman (the paper concludes there wasn’t any–thanks to Regulation SHO).

Why is this important now?

The SEC is reviewing its short selling regulations.  It has just reinstated a modified uptick rule and proposes looking at naked shorting next.  There’s bound to be brokerage industry argument that Regulation SHO isn’t needed because naked shorting wasn’t a factor in the collapse of financial stocks in 2008.  But that’s just not true.


Short-selling and the uptick rule

February 26, 2010 By in Basic Concepts, short selling, uptick rule Tags: , , , , , , Leave a comment

The SEC has been holding hearings about reinstating the “uptick rule” for short-selling in the US market, and has come up with a new rule.  The rule-making comes as a reaction to assertions that the Wall Street decline in late 2008 was made worse by speculative short sellers taking advantage of the removal of the uptick rule in 2007.  What are the issues?

short-selling

A short seller borrows stock from an owner, promising to return it on demand, and  promptly sells it.  The debt to the owner is expressed, not in dollars, but in a specific number of shares of a certain stock.  So at some point, the short seller must buy the stock back in the market and return it.  This can happen because the short seller decides his investment idea has outlived its usefulness, or because the original owner “calls” the stock back to him.

why sell short?

The short seller may think the stock in question will go down, so that he can make money by buying it back at a lower price and then returning it to the original owner.

Or he may have a hedging strategy in mind (this was the original “hedge fund” idea).  If so, he will reinvest the sale proceeds in something else he thinks will do better than the stock he sold short.  He might, for example, short Toyota and go long (i.e., buy) Ford.  In this case, he will make money if Ford goes up more, or down less, than Toyota.  He doesn’t need the stock he’s betting against to be an absolute loser, just a relative one.

Short selling is highly institutionalized on Wall Street.  Many financial firms and most large institutional investors have stock lending departments, which deal with each other to facilitate short selling by locating and arranging for stock to be borrowed and arranging for collateral to be provided.  (As a portfolio manager, I understood why my firm would do stock lending.  It didn’t thrill me, though.  It always irked me on those occasions when, despite their promises to the contrary, the borrower refused to return a stock I wanted to sell.)

Then, of course, there was the incredible disaster at AIG–and apparently other middlemen as well–where that company took the collateral it was holding, typically Treasury bonds, sold it and replaced it with sub-prime mortgage securities so it could earn higher interest income.  After sub-prime mortgage securities tanked, short sellers couldn’t close out their positions because AIG couldn’t give them back their collateral.  AIG needed another $40 billion+ from the government to clean up this mess.  But that’s another story.

the uptick rule

The uptick rule was instituted for exchange-traded stocks by the SEC in 1938, in response to a market swoon in 1937.  The SEC believed the market’s fall was caused, or at least made considerably worse, by rampant speculative short selling.  In response to brokerage industry lobbying, the rule was rescinded in July 2007–just at the beginning of a sharp market contraction made considerably worse, in the view of many, by rampant speculative short selling.

The rule was that you could only sell a stock short on an uptick.  That is to say, you could only sell a stock short either:

–at a price higher than the immediately previous trade, or

–at the same price as the previous trade, if the last price that was different from the previous trade was a lower price.

Put in less precise terms, the rule says that if a stock is declining you can’t hold it down or push the price even lower  by selling it short.  You can only sell short into a rebound (and thereby prevent that rebound from advancing), but if the stock turns lower again, you have to stop selling it short.

Remember, none of this prevents a “natural” seller (someone who owns the stock) from selling.  The uptick rule only applies to short sellers.

the new rule

The SEC has just instituted a new, limited anti-short selling rule.  It applies only to stocks which have fallen by 10% in price during a trading day, and applies only to the remainder of that trading day and the following trading day.

During that time, a stock may only be sold short if the sale price is higher than the highest bid price maintained by any market maker in the stock.  In other words, the short sale trade has to establish an uptick.

The main untested feature of the new rule is that it only kicks in after a stock has fallen by 10%  Before that, it’s a free-for-all.  It may well happen that market makers decide to move the market in a stock that’s being sold short down as fast as possible to the 10% mark, where they receive temporary protection against short sellers.  In my experience, that’s what happens in foreign markets when market makers encounter any sort of concerted selling.

“naked” shorts are much more important, I think

I don’t find anything particularly wrong with short selling–I should mention, though, that I worked on, and later ran, a (very successful) short portfolio in the early Eighties.  I’m also not sure that the uptick rule is a significant issue.

If anything, there may be unintended negative consequences.  My experience outside the US with markets that put arbitrary, or commodity market-like, restrictions on selling is that they end up with declines that are longer in time and deeper in extent than similar markets that don’t have such restrictions.

I think that colorfully named “naked” shorts are a much more significant concern.  More on that topic in my next post.