Stripped bare
20 August 2013
Recent lawsuits around naked shorting prove that the practice still has an army of critics. So who is fighting for it? SLT finds out
Image: Shutterstock
鈥淎busive鈥�, 鈥渓ike a form of terrorism鈥� and 鈥渇unny paper鈥漚re three descriptions of naked short selling, given by the 网爆吃瓜 and Exchange Committee, a life insurance company CEO, and broker-dealer Jeffrey Wolfson, respectively.
They do not do much to dispel the belief of naked shorting as a practice that is even worse than selling a borrowed security, only to buy it back at a lower price鈥攚hat we know as covered short selling.
Selling a security that you haven鈥檛 even borrowed is an abstract concept, which of course is where most trading strategies get into trouble in the press鈥攁nd where headlines are made.
鈥淐rackdown on short-selling leaves the city鈥檚 robbers in pinstripes facing huge losses鈥� screamed a Daily Mail headline from 2008. The article also quoted Liberal Democrat Treasury spokesman Lord Oakeshott as saying: 鈥楾hey don鈥檛 like the exposure. They want to remain anonymous so they are closing, not disclosing. They thrive in the dark and are totally unaccountable.鈥�
CEO Brian Pardo was similarly expansive when lamenting what he called illegal short selling in stock of his life insurance company.
Pardo said: 鈥淚t is a tragedy to realise that there are well-known financial entities that intentionally try to destroy companies with these abusive tactics, without any regard for the lives of the workers and the investors they ruin.鈥�
鈥淭he original purpose of our financial markets was to bring capital to companies so they could grow and, in turn, contribute to the growth of our whole economy. This small group has hijacked our financial markets for their own gain. I just hope that the SEC will use the clear evidence we have provided to them to bring those who are working against our economy to justice. In my view, naked short selling is a form of financial terrorism.鈥�
Financial Industry Regulatory Authority settlements with UBS and Credit Suisse speak to the enormous magnitude of naked short selling, said Pardo in his complaint. He also pointed to the recent SEC settlement with the Chicago Board Options Exchange as showing: 鈥淗ow an self-regulatory organisation was compromised by those who engage in naked short selling.鈥�
The exchange agreed to pay a $6 million penalty and implement major remedial measures to settle the SEC鈥檚 charges, which were that the firm suffered systemic breakdowns in its regulatory and compliance functions, including a failure to enforce or even fully comprehend rules to prevent abusive short selling.
Another blow to the practice was the case of Jeffrey and Robert Wolson. The brothers allegedly generated more than $17 million from naked short selling transactions involving stocks such as Chipotle Mexican Grill, Fairfax Financial Holdings, Novastar Financial, and NYSE Group. As Jeffrey Wolfson stated in a recorded telephone conversation: 鈥淲hat I sell them is not guaranteed, it never gets delivered, it鈥檚 funny paper.鈥� They agreed to pay more than $14.5 million to settle the case against them.
The SEC has taken considerable measures to stop naked shorting. Market participants were required to begin complying with Regulation SHO in 2005, which established uniform locate and close-out requirements in order to address problems associated with failures to deliver, including potentially abusive naked shorting. Though it did not outlaw the practice all-together (and indeed praised it as liquidity-generating, 鈥渋n certain circumstances), 2008 saw the issue grow cloudier.
As Fannie Mae and Freddie Mac were being tossed around the markets, the SEC announced emergency actions to limit naked shorting of government-sponsored enterprises, and six months later issued more extensive rules, which managed to include market makers.
But where there are detractors, there are also proponents. Three years ago, the German Minister of Finance announced that naked short selling of euro-denominated government bonds, credit default swaps based on those bonds, and shares in Germany鈥檚 10 leading financial institutions were prohibited.
But it didn鈥檛 take long for the International Monetary Fund to dismiss the measure, stating in a report that the ban did relatively little to support the targeted institutions鈥� underlying stock prices, while liquidity dropped and volatility rose substantially. It added that there was no strong evidence that stock prices fell because of shorting.
A new study has backed up statements such as these, in claiming accounting fundamentals, rather than manipulation, to be more significant in explaining naked short sales.
Naked Short Selling: Is It Information-Based Trading? is authored by Harrison Liu of the University of Texas San Antonio, and Sean McGuire and Edward Swanson of Texas A&M University. Its findings show that鈥攃ontrary to accepted belief鈥攁ccounting fundamentals are highly significant in explaining naked short sales.
Liu, McGuire and Swanson looked at 2700 firms鈥� fail-to-deliver data from 2005 to 2008, collected by the stock exchanges and provided by the SEC under the Freedom of Information Act, to decompose total short interest into naked and covered components.
It then came up with three main hypotheses: that accounting fundamentals are highly significant in explaining naked short sales; that recent actions by regulators to eliminate naked short sales are likely to impede informed arbitrage and reduce market efficiency; and that naked short sales contain incremental information about future stock prices.
The authors also stated that their results should be of considerable interest to both regulators and defendants in ongoing litigation.
鈥淐iting a widely held belief that naked short selling is not based on company fundamentals, the SEC (2008) has substantially tightened Reg. SHO close-out regulations in an effort to eliminate naked short selling,鈥� said the report鈥檚 foreword.
It went on to state that abnormal returns from a long/short trading strategy that buys (sells short) shares with low (high) short interest are more than seven times larger using naked and covered short interest, compared to returns using only covered short interest (15.2 percent versus 2.1 percent annualised).
鈥淎ll trading positions carry some incremental information about the value of a stock price, whether that is an upward/buying pressure, or a selling/downward one,鈥� says David Lewis, senior vice president at SunGard鈥檚 Astec Analytics business.
鈥淣aked short sales are no different in this respect and their influence should be included in any trade flow analysis.鈥�
Turning to accounting fundamentals, the report cited Diamond and Verrecchia, who predicted that the proportion of uninformed traders increases as the cost of short selling decreases. Naked short sellers have lower costs than covered short sellers because they receive an (involuntary) zero-fee, zero-rebate equity loan from the buyer, and the logic of Diamond and Verrecchia suggests that naked short sellers are potentially less informed than covered short sellers and, thereby, less likely to trade on accounting fundamentals.
In discussion of the report, Lewis adds that the view of naked short sellers as uninformed is a 鈥渄ramatic oversimplification.鈥�
鈥淭here have been viewpoints raised that naked short sellers are less informed than those that are covered, partly due to their avoidance of costs associated with covering their short sales.鈥�
鈥淭his would imply that the naked short sellers could be characterised as, say, an individual day trading from home as opposed to organised regulated banks undertaking proprietary trading. The implication is that the trading desks operated by the banks have a wealth of information available to them and are more likely to make decisions based on more information.鈥�
鈥淭his is, potentially, a dramatic over simplification. Whilst I think it is easy (and perhaps accurate in some cases) to liken naked short sellers to a group of people at the bookmakers betting on races as they come up during the day, based simply on a hunch or tips read in the racing post, it is too much of a generalisation to assert that they are all less informed.鈥�
鈥淎ll short sellers, big or small, expose themselves to potentially unlimited losses when they take out a short position. Unlike a bet on a horse, get it wrong and you lose more than your stake鈥攖he share price can keep on rising and your losses can explode. It would follow, therefore, that any trader placing such a 鈥榖et鈥� would do so carefully and with as much investment in research as they could afford in time and money. It could be argued the other way in fact鈥攄ay traders trade with their own money鈥攂ank traders could, theoretically, take less care as it is not their money at stake.鈥�
The report examined whether naked short sales are based on company, rather than accounting, fundamentals, by regressing naked short interest on financial statement fundamentals (and a set of control variables) to determine whether naked short sellers use those data.
Findings concluded that naked short interest is significantly negatively associated with Piotroski鈥檚 F- Score鈥攚hich simply means that naked short positions are lower for firms with positive accounting fundamentals.
Naked short interest is therefore significantly positively associated with both capital expenditures and sales growth, findings showed. 鈥淧rior research shows that high capital expenditures and high sales growth tend to precede lower future returns,鈥� said the report. 鈥淣aked short selling is therefore significantly associated with each of our three measures of accounting fundamentals in the direction indicating proper use of the information.鈥�
Lewis adds that trading patterns and research into failed trade statistics imply that naked short sales are of a much shorter duration than their covered cousins; which could suggest that the exposure created by naked shorts is less than for covered trades due to their relatively limited life spans, but that is determined by the share in questions volatility during that period. 鈥淪ignificant gains and indeed losses can be made very quickly, whether covered or not,鈥� Lewis said.
But while the report makes some persuasive arguments for the practice, it is unlikely to cause many ripples in the outside world.
鈥淩egulators dislike naked short selling鈥攍ike shadow banking, the very terminology has taken on a dark tone of something better people just do not do,鈥� says Lewis.
鈥淚ncreased legislation will no doubt increase the costs of undertaking naked short selling, but this will simply drive the trading towards other routes.鈥�
鈥淚mposition of a Financial Transaction Tax in France and Italy has seen equity trading decrease 30 and 45 percent respectively, yet tax exempt CFD and single stock futures trading have boomed. Eradication of naked short selling will not stop traders taking up positions reflecting negative sentiment over share valuations; other ways will be found to express market views and keep the market as efficient as it can be.鈥�
They do not do much to dispel the belief of naked shorting as a practice that is even worse than selling a borrowed security, only to buy it back at a lower price鈥攚hat we know as covered short selling.
Selling a security that you haven鈥檛 even borrowed is an abstract concept, which of course is where most trading strategies get into trouble in the press鈥攁nd where headlines are made.
鈥淐rackdown on short-selling leaves the city鈥檚 robbers in pinstripes facing huge losses鈥� screamed a Daily Mail headline from 2008. The article also quoted Liberal Democrat Treasury spokesman Lord Oakeshott as saying: 鈥楾hey don鈥檛 like the exposure. They want to remain anonymous so they are closing, not disclosing. They thrive in the dark and are totally unaccountable.鈥�
CEO Brian Pardo was similarly expansive when lamenting what he called illegal short selling in stock of his life insurance company.
Pardo said: 鈥淚t is a tragedy to realise that there are well-known financial entities that intentionally try to destroy companies with these abusive tactics, without any regard for the lives of the workers and the investors they ruin.鈥�
鈥淭he original purpose of our financial markets was to bring capital to companies so they could grow and, in turn, contribute to the growth of our whole economy. This small group has hijacked our financial markets for their own gain. I just hope that the SEC will use the clear evidence we have provided to them to bring those who are working against our economy to justice. In my view, naked short selling is a form of financial terrorism.鈥�
Financial Industry Regulatory Authority settlements with UBS and Credit Suisse speak to the enormous magnitude of naked short selling, said Pardo in his complaint. He also pointed to the recent SEC settlement with the Chicago Board Options Exchange as showing: 鈥淗ow an self-regulatory organisation was compromised by those who engage in naked short selling.鈥�
The exchange agreed to pay a $6 million penalty and implement major remedial measures to settle the SEC鈥檚 charges, which were that the firm suffered systemic breakdowns in its regulatory and compliance functions, including a failure to enforce or even fully comprehend rules to prevent abusive short selling.
Another blow to the practice was the case of Jeffrey and Robert Wolson. The brothers allegedly generated more than $17 million from naked short selling transactions involving stocks such as Chipotle Mexican Grill, Fairfax Financial Holdings, Novastar Financial, and NYSE Group. As Jeffrey Wolfson stated in a recorded telephone conversation: 鈥淲hat I sell them is not guaranteed, it never gets delivered, it鈥檚 funny paper.鈥� They agreed to pay more than $14.5 million to settle the case against them.
The SEC has taken considerable measures to stop naked shorting. Market participants were required to begin complying with Regulation SHO in 2005, which established uniform locate and close-out requirements in order to address problems associated with failures to deliver, including potentially abusive naked shorting. Though it did not outlaw the practice all-together (and indeed praised it as liquidity-generating, 鈥渋n certain circumstances), 2008 saw the issue grow cloudier.
As Fannie Mae and Freddie Mac were being tossed around the markets, the SEC announced emergency actions to limit naked shorting of government-sponsored enterprises, and six months later issued more extensive rules, which managed to include market makers.
But where there are detractors, there are also proponents. Three years ago, the German Minister of Finance announced that naked short selling of euro-denominated government bonds, credit default swaps based on those bonds, and shares in Germany鈥檚 10 leading financial institutions were prohibited.
But it didn鈥檛 take long for the International Monetary Fund to dismiss the measure, stating in a report that the ban did relatively little to support the targeted institutions鈥� underlying stock prices, while liquidity dropped and volatility rose substantially. It added that there was no strong evidence that stock prices fell because of shorting.
A new study has backed up statements such as these, in claiming accounting fundamentals, rather than manipulation, to be more significant in explaining naked short sales.
Naked Short Selling: Is It Information-Based Trading? is authored by Harrison Liu of the University of Texas San Antonio, and Sean McGuire and Edward Swanson of Texas A&M University. Its findings show that鈥攃ontrary to accepted belief鈥攁ccounting fundamentals are highly significant in explaining naked short sales.
Liu, McGuire and Swanson looked at 2700 firms鈥� fail-to-deliver data from 2005 to 2008, collected by the stock exchanges and provided by the SEC under the Freedom of Information Act, to decompose total short interest into naked and covered components.
It then came up with three main hypotheses: that accounting fundamentals are highly significant in explaining naked short sales; that recent actions by regulators to eliminate naked short sales are likely to impede informed arbitrage and reduce market efficiency; and that naked short sales contain incremental information about future stock prices.
The authors also stated that their results should be of considerable interest to both regulators and defendants in ongoing litigation.
鈥淐iting a widely held belief that naked short selling is not based on company fundamentals, the SEC (2008) has substantially tightened Reg. SHO close-out regulations in an effort to eliminate naked short selling,鈥� said the report鈥檚 foreword.
It went on to state that abnormal returns from a long/short trading strategy that buys (sells short) shares with low (high) short interest are more than seven times larger using naked and covered short interest, compared to returns using only covered short interest (15.2 percent versus 2.1 percent annualised).
鈥淎ll trading positions carry some incremental information about the value of a stock price, whether that is an upward/buying pressure, or a selling/downward one,鈥� says David Lewis, senior vice president at SunGard鈥檚 Astec Analytics business.
鈥淣aked short sales are no different in this respect and their influence should be included in any trade flow analysis.鈥�
Turning to accounting fundamentals, the report cited Diamond and Verrecchia, who predicted that the proportion of uninformed traders increases as the cost of short selling decreases. Naked short sellers have lower costs than covered short sellers because they receive an (involuntary) zero-fee, zero-rebate equity loan from the buyer, and the logic of Diamond and Verrecchia suggests that naked short sellers are potentially less informed than covered short sellers and, thereby, less likely to trade on accounting fundamentals.
In discussion of the report, Lewis adds that the view of naked short sellers as uninformed is a 鈥渄ramatic oversimplification.鈥�
鈥淭here have been viewpoints raised that naked short sellers are less informed than those that are covered, partly due to their avoidance of costs associated with covering their short sales.鈥�
鈥淭his would imply that the naked short sellers could be characterised as, say, an individual day trading from home as opposed to organised regulated banks undertaking proprietary trading. The implication is that the trading desks operated by the banks have a wealth of information available to them and are more likely to make decisions based on more information.鈥�
鈥淭his is, potentially, a dramatic over simplification. Whilst I think it is easy (and perhaps accurate in some cases) to liken naked short sellers to a group of people at the bookmakers betting on races as they come up during the day, based simply on a hunch or tips read in the racing post, it is too much of a generalisation to assert that they are all less informed.鈥�
鈥淎ll short sellers, big or small, expose themselves to potentially unlimited losses when they take out a short position. Unlike a bet on a horse, get it wrong and you lose more than your stake鈥攖he share price can keep on rising and your losses can explode. It would follow, therefore, that any trader placing such a 鈥榖et鈥� would do so carefully and with as much investment in research as they could afford in time and money. It could be argued the other way in fact鈥攄ay traders trade with their own money鈥攂ank traders could, theoretically, take less care as it is not their money at stake.鈥�
The report examined whether naked short sales are based on company, rather than accounting, fundamentals, by regressing naked short interest on financial statement fundamentals (and a set of control variables) to determine whether naked short sellers use those data.
Findings concluded that naked short interest is significantly negatively associated with Piotroski鈥檚 F- Score鈥攚hich simply means that naked short positions are lower for firms with positive accounting fundamentals.
Naked short interest is therefore significantly positively associated with both capital expenditures and sales growth, findings showed. 鈥淧rior research shows that high capital expenditures and high sales growth tend to precede lower future returns,鈥� said the report. 鈥淣aked short selling is therefore significantly associated with each of our three measures of accounting fundamentals in the direction indicating proper use of the information.鈥�
Lewis adds that trading patterns and research into failed trade statistics imply that naked short sales are of a much shorter duration than their covered cousins; which could suggest that the exposure created by naked shorts is less than for covered trades due to their relatively limited life spans, but that is determined by the share in questions volatility during that period. 鈥淪ignificant gains and indeed losses can be made very quickly, whether covered or not,鈥� Lewis said.
But while the report makes some persuasive arguments for the practice, it is unlikely to cause many ripples in the outside world.
鈥淩egulators dislike naked short selling鈥攍ike shadow banking, the very terminology has taken on a dark tone of something better people just do not do,鈥� says Lewis.
鈥淚ncreased legislation will no doubt increase the costs of undertaking naked short selling, but this will simply drive the trading towards other routes.鈥�
鈥淚mposition of a Financial Transaction Tax in France and Italy has seen equity trading decrease 30 and 45 percent respectively, yet tax exempt CFD and single stock futures trading have boomed. Eradication of naked short selling will not stop traders taking up positions reflecting negative sentiment over share valuations; other ways will be found to express market views and keep the market as efficient as it can be.鈥�
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