July 17, 2008 12:54PM
SEC Chairman Answers Critics
By Alexis Glick
Ask and you shall receive. If you read my blog, about five blogs back on the SEC entitled “Concerned by the SEC’s Latest Moves,” you’ll know that I had a lot of unanswered questions about what Chairman Christopher Cox was up to with this new emergency measure to curb naked short selling in 19 financial institutions.
This morning he joined me on Money for Breakfast to address many of the concerns that I listed in that last blog and the growing speculation that the SEC has failed to do its job and is now stepping in to protect those institutions. Institutions that have been given access to the discount window, some temporarily, to prevent further losses at these institutions, and in turn, prevent losses to the U.S. government, (i.e. the taxpayer), which has become the back stop for many of these institutions.
Take a look at how he answered his critics.
Comment by chuck
Jul 17th, 2008 at 2:15 pm
Question now: can the SEC’s thirty day window prevent harmful rumors from getting leaked. Rumors that could hurt an investment insutition or benefit from it. Can this prevent the next Bear Sterns? I believe one has to wait and see how this plays out and how it will affect the market in the long run.
Comment by lenofus
Jul 17th, 2008 at 2:31 pm
How refreshing to have an anchor with some chops.
Christopher Cox is a politician who has killed us with his cozy relationship with Wall St. Just look around? Who did this? Cavuto?
Stay on this, Alexis. Dig hard. Cnbc soft soaps this. I think you know how serious it is.
Comment by Evren Karpak
Jul 17th, 2008 at 3:02 pm
In this interview Cox calls naked shorting:
legal
illegal
should be illegal
manufacture of shares that don’t exist
There is but one description for naked shorting and that is that it is illegal, wrong and akin to stealing and counterfeiting. A short becomes a naked short only when the seller delivers no shares to the buyer (unbeknownst to the buyer). Just as “sex” is legal and “sexual harassment” is not, the legality of “shorting” does not lend any legality to “naked shorting”. Cox and the SEC has dropped the ball on this and trying to cover his tracks. Ms Glick asks great questions but does not call Cox on his evasions.
Comment by Thomas Vallarino
Jul 17th, 2008 at 3:03 pm
Chairman Cox does not know his own rules. He even contradicted himself in the interview. On the one hand he is explicit that naked short selling is not illegal and then a few moments later says it is.
We at the National Investor Protection Coalition agree with his latter statement. All Naked short selling is illegal. Why? Well because there already is a mandatory 3 day delivery requirement. It’s called rule 15c6-1 - the 3 day settlement cycle rule. It’s binding and mandatory on everybody.
If COX is saying that for some, the 3 day settlement cycle rule does not apply, making some naked short sales legal, then we would like to know what rule or law he is referring to.
Believe me, there is no such rule. The body of rules he mentions, REG SHO, that is supposed to limit naked short selling has been utterly ineffective - and he even says as much in the interview. Just as the number of short sales has jumped over the past few years, so has the number of phantom stock - undelivered stock - that is caused by naked short selling. The SEC calls these “fails to deliver”.
What’s the solution? Follow already existing law and enforce it. The questions put to him are well founded. The SEC has failed to enforce the law and makes up excuses like the one we heard in the interview, where COX says some naked short sales are legal - which is just not true. All naked short sales are illegal without exception.
Comment by kyoto27
Jul 17th, 2008 at 3:23 pm
Bravo Alexis Glick for staying on message –a welcome relief vs CNBC!
Also interesting that the more everyone in the “not” captured media stays on message the more our regulators are beginning to trip over their own words. In your interview Cox has used the term “illegal naked short selling” and then caught himself (?)and turned around and said naked short selling is not illegal. I hope you follow-up with the most obvious of concerns for all of us retail investors: The SEC has to extend the NSS ban to the entire market. Period! To protect those very institutions who were behind much of the broader market NSS is something out of Alice in Wonderland. But that’s for another day….Once again, bravo!
Comment by kyoto27
Jul 17th, 2008 at 3:34 pm
Alexis, one more afterthought from ‘investigate the sec’ on why the SEC is being so restrictive with its narrow focus on the 19 financial firms (even though they are the ones–as you noted & Cox confirmed) that have access to the discount window:
“When asked why the list was so restrictive an SEC official said the agency focused on financial firms that were of a significant size. “Drastic falls [in stock prices] can end up destroying confidence in the firm altogether, which is not true for bricks-and-mortar industrial companies,” the official said.
Apparently this SEC Official has lost touch with how the investing public invests their capital.
Take any thinly capitalized company looking to grow under the protective umbrella of the US Capital Markets. Each relies heavily on share value to raise capital to re-invest in development. Share value requires long term investor interest in the company’s future.
Now add the drastic and uncontrollable fall in stock pricing due to abusive short selling.
What results is a loss of confidence in company growth by the limited investment base this thinly capitalized company can attract. This loss in confidence further impacts stock pricing and makes it far more difficult to raise necessary capital to succeed. It only takes a short window of time before a growing company stall under the pressures of a death spiral. Those investors lost will forever be lost from future re-investing because that is how an investor thinks.
Once burned never return to the fire.
The abuse to these thinly traded companies takes place through a network of abusers but in the end the network can only be facilitated with the aid of the very institutions Chairman Cox just threw the lifeline to.
When the trade fails settlement it is the Goldman Sachs, the Lehman’s, the Merrill Lynch’s, the Morgan Stanley’s, and all the other prime brokerage houses who hold these fails on their books indefinitely. Each colludes with each other to dismiss the settlement responsibilities associated with the contract to settle they agreed upon. The 3-day settlement periods are ignored for trade commissions, liquidity, and the rights to future business from those who sold what did not exist.
If any company in the US Capital Market deserves an umbrella of protection it is a company publicly recognized as over-burdened with settlement failures. These companies are not hard to find, the list is published daily by the major market centers, it is called the Regulation SHO threshold security list and there are 591 public companies identified today.
Taking a closer look at the SEC’s special list of protected entities none are SHO threshold securities. By choosing non-SHO companies put protecting such against naked short sales falling below 0.5% the SEC is making admissions that in highly capitalized companies it does not take 0.5% of the shares outstanding to fail to achieve manipulation levels. What exactly does that say about the threshold levels defined?
The real solution lies with a division of the SEC that has yet to accept that this abuse exists.
The SEC’s Division of Trading and Markets that is responsible for drafting rule changes that address the evolution of trading patterns in the industry to insure as trading patterns shift abuses are not the resultant outcome. When it comes to short selling a Committee led by James Brigagliano has been working [ignoring] the underlying issues of short sale abuses. Brigagliano has failed to conceptualize that liquidity generated from shares that do not exist is not healthy liquidity regardless of market capitalization so what we have are fractured rules and gaping loopholes.
The solution for Chairman Cox is simple.
First, the SEC must expand this executive order to include all issuers listed under Regulation SHO until such time as the Division of Trading and Markets can get their act together and propose to the Commission staff permanent rule changes.
Second, the proposed rule changes should strictly prohibit the options market maker from engaging in a naked short into the equity market to hedge their book. If the market maker chooses to allow the book to get vastly out of balance due to their pricing strategies the only option available to them on a hedge would be to short the equity similar to any other public investor. There can no longer be the unlimited volume of Put contracts issued against a public company where the resultant is unlimited naked shorts exercised into the equity market at the expense of long equity investors.
Third, the SEC must reconstruct the uptick rule to a level that is functional to today’s pricing increments. The elimination of the rule has shown that the opportunity to overwhelm pricing stability with short sale domination can and will create a market panic that destabilizes the markets.
Finally, the SEC must place firm constraints on how long a failed trade exists regardless of level of fails in a market. There are few valid reasons for a failed trade to persist for any length of time, including bona fide market making, and thus limits must be placed on what is considered a reasonable effort before additional more drastic steps will be required. The SEC can no longer allow the institutions that facilitate these fails to ignore them because it is not cost beneficial to have them closed. That is not an option affordable to the marketplace.
Naked Shorting finally made it to the front pages but it took the destruction of the #5 US banking institution, the near destruction of the #4, and several more sitting on this fence to get Washington to take this seriously. Unfortunately, while these may represent huge market capitalization losses it pales relative to the total capitalization losses incurred over the hundreds of smaller companies abused and those smaller investors. It also pales in comparison to the jobs and technologies lost to this abuse.
For more on this issue please visit the Host site at http://www.investigatethesec.com
Comment by Jason
Jul 17th, 2008 at 3:46 pm
Thank You Alexis. CNBC journalists are clueless when it comes to this issue… excluding Erin Burnett. Please keep this story alive.
Jason
Comment by chuck
Jul 17th, 2008 at 5:41 pm
How many companies and investors have beneifited from naked short selling? Has that crossed anyone mind on the Street?
Comment by kyoto27
Jul 18th, 2008 at 2:48 pm
Alexis–a little more food for thought and hope you get a chance to ask Sec Cox for a follow-up:
SEC Trips at Finish Line; Fraud Wins
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.
Dave Patch
http://www.investigatethesec.com/drupal-5.5/node/338