July 18, 2008

Naked Shorts Bother You?

I cringed when SEC chief Christopher Cox moved to prohibit naked shorts against Fannie and Freddie. And not just because my inner Beavis and Butthead heard Cox, naked, shorts, and Fannie in the same sentence.

In my mind, a naked short is a pure derivative play that allows a trader to bet on a stock's going down. I'm a dull, broad-index, ETF guy myself, but I believe pure option plays provide more efficient price information and get risk in the hands of those who can best handle it. This call from a sharp GOP administration official like Cox sounded like blaming oil prices on "evil speculators."

To my surprise, Donald L. Luskin strongly criticized the practice on Kudlow last night. I just sent a letter to Mr. Luskin suggesting that he expound on it. (Heh: just got a response, he says "Done." While I was typing this he answered and posted a response.)

"Naked" shorting and "naked" option-writing have nothing to do with each other, except for the coincidence of the term "naked." In the case of option-writing, the "naked" writer is simply taking a short position in a put or a call without a risk-offsetting position in the underlying asset (usually a stock). I have no problem with that at all. A short option, whether "naked" or not, is simply a contract to sell (in the case of a short call) or buy (in the case of a short put) at a fixed price by a fixed date. No issue there.

However, "naked" shorting is an entirely different matter. When you sell a stock short, you are selling something you do not own. Yet the buyer requires that you deliver to him the thing he bought from you. Normally you accomplish that by arranging to borrow the shares from someone else who owns them. You sell the borrowed shares, and deliver them to the buyer in exchange for the buyer's cash. Ultimately, you expect to buy back the stock at a lower price, and replace the borrowed shares. In "naked" shorting, you sell to the buyer without any intention of borrowing stock to deliver. So on settlement day, your trade fails. You cannot deliver what you do not have. Yet when you made the sale, you were implicitly promising to deliver. After the fail, you can cure the problem by buying stock and delivering it, hopefully at a profitably lower price. But shat amounts to fraud -- in very much the same way that kiting checks amounts to fraud. It doesn't matter if you ultimately deliver. At the time of the sale, you had no intention or capability to deliver.


The WSJ Editorial page today is a little closer to my position. They're not full-throated endorsers by any means:
Not that the SEC's emergency order to bar naked short selling is quite the disaster proclaimed by some traders. It's possible that it won't do much harm, and this is a titanic achievement for any policy coming out of Washington these days. At the end of the day, the order is not a ban on all short selling, which is a bet that a stock price will fall and is a critical ingredient for efficient markets.

Will the SEC rule prevent the 19 designated financial firms from reaching the valuations that investors would otherwise assign to them? Probably not. The only certain result is that Wall Street trading desks and IT departments will spend time and money scrambling to reconfigure their transaction systems by 12:01 a.m. Monday when the order becomes effective. This is sand in the gears of our financial markets and at the margin may slow down vital price signals, given the extra step required to lock down the shares before shorting them. In that way it may not benefit the firms it is intended to help because it will reduce liquidity.


I am on vacation, so I have some time to ponder Luskin's response. I understand the technical difference but I am not sure I grab a philosophical difference that makes one side a legitimate play and the other the equivalent of kiting checks. I'm keeping an open mind.

Economics and Markets Posted by jk at July 18, 2008 11:42 AM

The Refugee thinks that Mr. Luskin is using the definition of "kiting" at loosely. Here is a great discussion of kiting. Basically, kiting is going from one instition to another with intent to defraud. In other words, one writes a check on Bank A to pay Bank B, and on Bank B to pay Bank C. Since the banks (often) give immediate credit for a deposit, even though they have not actually received the funds through the system.

This is very different from check floating. When one floats a check, one might pay a bill by check and drop it in the mails knowing that he has insufficient funds at that moment. He also knows that it will take a day for the mail to be delivered and another day for the check to be deposited. Therefore, on day 2 he transfers funds to cover the check. While acknowledging that this is technically illegal, The Refugee will admit to having done such and suspects that most bill payers have done so at one time or another. The key is no intent to defraud; the funds are there to cover the withdrawal. It is worth noting that that neither the financial institution nor the the Fed look at mail and deposit timing and says, "Wait, it's not possible..."

The Refugee believes that short selling contains no attempt to defraud and is therefore not analogous to kiting. If one sells short and guesses wrong, he must pay the difference and take the loss in a timely manner - just like covering a check. Open financial markets are critical to efficiency and liquidity.

One final note on efficiency. Unlike buying an selling stocks, deriviatives are a zero-sum game. For every winner, there is a corresponding loser. That's what makes them so efficient (and brutal to the casual investor). They are a perfect reflection of accurate pricing in the marketplace. If you eliminate the possiblity of either selling or buying under certain conditions, then the efficiency is lost. Some investors, rather than losing part of their investment, will lose it all. That additiona risk will be built into the equation causing even greater volitility.

Posted by: Boulder Refugee at July 18, 2008 12:44 PM

I almost offered the disclaimer that this ex dirty hippie guitar player had indeed practiced bona-fide check kiting. Write rent check on account A on the 29th. Deposit check from account B into account A on the 31st. Deposit money into account B on the 3rd. You can tell from the date spreads this was a long time ago. Computers killed the kiting star.

The comparison seems apt because the check kiter has intent to pay, yet it clearly is fraudulent.

Posted by: jk at July 18, 2008 1:27 PM

Coincidentally, I was explaining this to someone at lunchtime. Luskin is correct.

BR, you bring up derivatives, efficiency, etc., but those are beside the point. Re-read what Luskin said. This isn't about *all* short-selling, but a kind of short-selling that can very well be fraudulent.

Some people think that short-selling should be illegal, because it's supposedly selling something you own. No, you're selling something that you've *borrowed*, with the contractual promise to repay what you borrowed (by definition you're borrowing and repaying something fungible).

But naked shorting is entirely different, which were my words too at lunchtime. Naked shorting means you haven't even borrowed the shares yet. So as Luskin points out, let's say you want to short-sell XYZ. You're getting money with the implicit promise that you'll deliver the agreed-upon number of shares at settlement time. That means you have to borrow the shares by the end of settlement. So it *is* like check-kiting, because settlement typically won't happen for a few business days -- you'll have that much time to borrow the shares. But what if you can't? And that's the problem: it's entirely possible for the number of shorted shares to increase the number of floating shares (meaning shares available on the market).

The WSJ editorial is so ignorant of how financial firms' technology works. There's no need for them to "scramble" to fix technology. All a company needs to do right now is a policy change: no naked shorting, with the threat of "disciplinary action, up to and including termination" if someone breaches that rule. Then the company can look at some way to audit

Where I'll disagree with Luskin, to a very very minor extent, is that naked shorting is necessarily fraudulent, because you're receiving the money and representing that you *at the time you sell* have the shares to deliver, but the short-seller might in fact have every intent to deliver. Maybe he thinks he can borrow them but then can't. That's also I don't believe there should be any "regulations." Rather than new SEC rules, there instead should be prosecution and incarceration of people who commit naked short-selling and then don't deliver the shares. People go to jail for writing bad checks, why not for short-selling shares and then failing to borrow and deliver? Both are fraud.

Disclosure: as some of you may remember, I'm a compliance analyst on the personal trading end. Our firm is very strict, more so than just about anyone else, particularly on short-selling. We don't allow our employees to short anything that's long in our clients' portfolios.

Posted by: Perry Eidelbus at July 18, 2008 5:03 PM

The Refugee will agree with some of what PE says, that is failure to cover a short should be treated the same as writing a bad check.

That said, I disagree with the basic premise that naked shorts are inherently fraudulent. As an analogy, when I go to the bank and borrow money to buy a house, I'm representing that I'll be able to pay it back. Obviously, I do not have the money at this time to cover the debt. I'm betting that I'll earn the money in an amount and time to pay it back according the covenants. However, I may lose my job that would prevent me from paying back. Fraudulent? No. Of course, I'll lose the house and whatever equity I put into it. I realize it could be a fraudent transaction if I lie about my income or circumstances, but that fact that I do not today have the money to repay the loan does not in itself constitute the basis fraud, or we'd all be in jail.

Posted by: Boulder Refugee at July 22, 2008 3:45 PM | What do you think? [4]