Post by ginger on Apr 3, 2006 17:08:40 GMT -4
Part Two - Experts Speak Out - Dr. Susanne Trimbath
Location: Blogs Bob O'Brien's Sanity Check Blog
Posted by: bobo 4/2/2006
A week or so ago we got the first installment in our new "Experts Speak Out" series, featuring Dr. Trimbath. Here is the next installment in her responses to questions posed to her by the Bunny and you, our readers:
9) What can we in the U.S. learn about either securities regulation or safeguarding the settlement process from other securities markets in Europe or Asia? Are there routine procedures taken for granted elsewhere (such as providing daily information on short positions) that are somehow ignored or avoided here?
Fundamentally, Western European capital markets did develop somewhat independently of the US (an example would be France, which is quite different from the US market because of the different basis in law.) Capital markets in Eastern Europe and Asia, on the other hand, were developed based on the US model. (One notable exception is Malaysia where Islamic capital markets are quite well developed.)
However, when it comes to the processes, procedures and even the computer systems that make up the operational infrastructure of global capital markets, the US is the model – they have what we have. Two factors contributed to this state. First, the sheer size of US capital markets made them so dominant that foreign markets found it necessary to build compatible systems. (We are also notoriously slow to adapt to foreign influence: only foreign car specialists use the metric system in the US.) The other factor is the generous nature of the US taxpayer: we financed, via foreign aid, the development of capital markets in virtually every country beyond the G7. I worked in Russia (#8 in the Big G) and can tell you that we refused to give them shorts or stock lending in 1994 because of the known risk factors. [/color]
10) Enron went straight down once the bad news broke – and there was likely naked short selling going on. Likewise, WorldCom and Delta Airlines might be other candidates. All had hundreds of millions of shares outstanding--and if naked selling is as rampant in such situations as many think, then there may have been billions of share 'rights' outstanding when they were de-listed.
Given that the above might be true, do you:. 1) feel these issues would be good targets for a post hoc forensic examination; 2) consider that there is any possibility of success in doing a forensic exam, in demonstrating to what degree naked short selling played a role in their demise; 3) and if so how would you proceed with an in-depth forensic examination, the goal of which would be to lay proof of widespread naked short selling before investors who collectively lost billions, possibly due to the practice.
The primary difference I see in Enron and WorldCom, compared to the NSS cases I’m aware of, is that those companies were heavily “touted”. Did anyone *not* know what Ken Lay and Bernie Ebbers looked like before their companies collapsed? On the other hand, I’m a big hockey fan and I did not know that Melnyck owned the Ottawa Senators before I read the Gradient hatchet job. Also, I’m now convinced that criminal activity was taking place at Enron; I don’t know that we’ll find anything at Biovail that rises to that level.
The forensic accounting for Biovail is pretty straightforward: compare the hatchet job to the financial statements and find the lies. This wouldn’t work on Enron or WorldCom because the lies are in the financial statements.
The share “rights”, “entitlements” or “phantoms” are another matter altogether. The forensic accounting would look the same for every company because it wouldn’t involve their financial statements. [/color]
11) Do you think the DTCC has any valid reason(s) for declining to disclose data and information on the extent of FTDs either as to the market in general, or as to specific companies affected by the FTDs? If so, what is the reason(s)?
From their standpoint, disclosing who failed-to-deliver would be like your bank disclosing details of your bounced checks. Continuing the analogy, your bank is required to disclose certain data that reveals the risks they face (bad debts, for example). In that sense, it would behoove the DTCC to report to someone (whether or not the information is “public”) how much they are owed, by whom and for what in order for real risk analysis to take place. The Federal Reserve Bank (fiscal agent for the US government, the government’s bank, if you will) does disclose aggregate information about the risk in the banking system so why shouldn’t DTCC do this for the capital markets?
As for disclosing FTDs by issue (not by company, because one company could have multiple issues and they are not always easily connected), the analogy to banking fails to provide the answer. The Fed (and hence their member banks) all own shares in the same issue: US currency. (Put aside foreign currency considerations for the moment.) So whatever fail information is disclosed in banking is disclosed on the same issuer.
The question then becomes: what can be gained by knowing which issues are undelivered? (Bringing foreign currencies into the analysis still doesn’t help us because the difference between public companies traded in US capital markets is not as great as the difference between countries when we are measuring risk.) Clearly, as an investor I would like to have those issuer names in my information set because then I’d know how to calculate the actual supply of shares. The parties who are failing to settle know the identity of the issuer; I’m at a disadvantage to them based on information that they not only know but they in fact have (causative) control over. That’s the worst possible scenario for anyone working with a model of perfect capital markets, which requires that information be free and freely available. [/color]
12) Do you view the DTCC's Stock Borrow Program as a tool designed to serve the purpose and motive of naked short selling? Or has it just turned out that way?
The SBP is a large facilitator of NSS. SBP (at subsidiary NSCC and the inverse stock lending program at subsidiary DTC) was not designed to serve NSS. It was designed to reduce risk in the system by guaranteeing delivery of shares to every buyer in the event a seller could not honor its total obligation. While trade-for-trade settlement would leave only a singer buyer at risk for the actions of a single seller, net settlement spreads this risk to uninvolved parties. Therefore, the centralized system required a method, like SBP/SLP, to accommodate fails that made it all the way to settlement date. [/color]
13) In your opinion, what would be the effects (on shareholders, broker-dealers, hedge funds and others) of an SEC ruling that all FTDs be bought in upon expiration of 10 days after the trade?
I believe that there must be a time limit for FTDs, as well as a time limit for stock loans. As I told the audience at the November 29, 2005 forum held by the North American Securities Administrators, there is no such thing as an innocent fail. There is also no such thing as a strategic fail because failing to settle a trade is not a strategy – it is a failure of strategy.
The impact on shareholders would be beneficial – they would get what they actually paid for. Right now, they own phantom shares until the fail is cleared and in the meantime, the broker gets to play with their money for free.
The impact on the broker-dealers would be that they’d have to find a new source for free money, poor things! Seriously, if they’ve become dependent on this source of cash there would be a shakeout in the industry. There is likely a complete lack of knowledge at the retail level that would have to be corrected in order to maintain customer relations under the new paradigm.
The hedge funds should not have major difficulty with this because it is their business to arbitrage risk. Any hedge fund worth its salt would be able to manage under the new system just as well as it does now. How does a hedge fund hedge if the risks are hidden? The best funds should actually flourish under a system where the rules are clearly defined and well-understood.
The impact on others? There will be mass hara-kiri at the SEC and the DTCC before they put a limit on FTDs, so those organizations would need to embark on major recruiting campaigns to replace their fallen leaders. [/color]
14) Why do you think SEC chairman Donaldson chose to answer Senator Bennett's inquiries regarding naked short selling in closed session rather than in public?
Because he knows it’s a problem and couldn’t admit it in public without having his ceremonial knife handy. Because he knows that the problem described by NSS includes the problem of phantom shares, the proxy voting charade and the collapse of corporate governance. [/color]
15) Please elaborate on the companies that are almost completely destroyed by naked shorting especially on the Pinks or OTCBB stocks. I hear rumors of some of these stocks having 2-3 times the outstanding shares being short. Is this rumor true?
Why stop at 3 times outstanding shares? No one has yet proved that there is a limit to the multiplication, though there is a theory that some reporting requirements might stall the process at one month.
Keep in mind that it’s not just that the shares are shorted. It’s also that they are loaned and the loans are not repaid. It’s also that shares are not delivered for the settlement of trades, yet the retail brokerage customer accounts reflect the phantom shares. Economics 101: if you increase supply, you decrease price.
It’s not a rumor, it’s a fact. It’s a fact that the STA and the Business Roundtable have been talking to the NYSE, the DTCC and the SEC about for a decade. Read Drummond’s article in the April 2006 issue of Bloomberg Markets (p.96). Important corporate governance issues, including corporate sales and mergers, are already being controlled by criminal elements. [/color]
16) What is the corporate structure of Cede & Co.? Is it a trust? If it is a trust, where can we find the trust documents? What is the jurisdiction (it doesn't show up on a search for NY companies)? Who owns it? Who are the directors / management. Are securities registered to Cede pledge as security in any way? Why does Cede and its assets not show up in the DTCC annual report?
There is no trust company named Cede, no “company” in fact named Cede. Cede & Co. is a nominee name. It originated in the acronym CD which stood for something like central deposits, which was the name of the department at the NYSE that was the predecessor to the DTC which is now a subsidiary of the DTCC. You should simply look for Depository Trust Company. Shares registered to Cede & Co basically belong to the Participants who have shares on deposit there. [/color]
17) If a US participant buys from the Canadian Depository for Securities, does the trade always fail? The CDS position size will stay identical on position reports over time (once you net incoming / outgoing certs. into CDS). That seems impossible. Shouldn't some trades go into Canada or out of Canada? The only solution I can see is that shares deposited in Canada stay in Canada, even if the Canadians sell to Americans. Otherwise the security position report should show this account fluctuating wildly.
It seems that that is where much naked shorting comes from. The US participant goes "where are my shares?" and they say, "don't worry about it, they're in Canada".
CDS is the DTC of Canada, so DTC participants buy from CDS participants (not from CDS). Each depository has an account at the other depository that looks, for all intents and purposes, like another participant account. When I was with the Pacific (see “First Series of Interview Questions”), we had an account at DTC which was used for inter-depository settlement. So when CDS participants trade with DTC participants, there is a net settlement position for shares and cash between the two depositories that is settled out each day. The shares are always left in place, physically, for the sake of “immobilization.” Periodically, shares are withdrawn from one depository and re-registered for delivery to the other in order to manage the local inventory of share certificates. I remember once getting a panicked call from ITT when they say a massive movement of shares from Chicago (Midwest depository) to Cede – they wanted to know who in NY was buying up their shares and were they mounting a takeover attempt. The reality was that DTC was doing a drawdown of inventory from the Midwest, nothing more. [Well, maybe a little more. It turned out that DTC was doing the drawdown in anticipation of the Midwest depository closing down.]
Trades done with CDS participants do not always fail. I’ve forgotten the specific account names, but there should be a separate CDS account at DTC to reflect inventory (versus the position left behind after settlement). It’s when the inventory and the position diverge substantially that certificates are usually re-registered and moved.
While there are differences in the short selling rules in Canada that can create problems beyond what we already have in the US, it is not necessary to have trades with Canada to generate phantom shares. [/color]
18) Am I correct that the NSCC obligation to deliver shares to the net long participants is independent from the net short participant's obligation to the NSCC? In other words, if the seller flees, wouldn't the NSCC be on the hook for the shares?
The NSCC does put itself in the middle, so to speak, of every settlement obligation. In that sense, if any participant walks away from any obligation, the NSCC is on the hook. Their first line of defense is the participant fund, to which each user contributes an amount which is based on their activity. [/color]
19) I had drinks with a person who is expert in clearing on Friday. He said Patrick should do a rollback (he could always do a forwards split later) and change his CUSIP number. Is my friend right that this would force the system to reconcile all the claims into real shares?
No, your friend’s suggestion would most likely result in the issue being frozen at DTCC. Then not only can they not withdraw certificates, they won’t be able to make book-entry deliveries either. [/color]
20) How can any stock holder be sure he's holding genuine shares, as opposed to counterfeit? (Certificate holders excepted, of course.)
Direct registration: no certificate, electronic access to the market and you are registered with the issuer. Unfortunately, according to the Securities Transfer Association, the electronic access portion is poorly developed at the broker level; there is little or no training at the retail level; and the costs are borne entirely by the issuer. But if you have direct ownership, on the books of the issuer, there can be no question of your genuine shares. [/color]
Copyright ©2006 Bob O'Brien
Location: Blogs Bob O'Brien's Sanity Check Blog
Posted by: bobo 4/2/2006
A week or so ago we got the first installment in our new "Experts Speak Out" series, featuring Dr. Trimbath. Here is the next installment in her responses to questions posed to her by the Bunny and you, our readers:
9) What can we in the U.S. learn about either securities regulation or safeguarding the settlement process from other securities markets in Europe or Asia? Are there routine procedures taken for granted elsewhere (such as providing daily information on short positions) that are somehow ignored or avoided here?
Fundamentally, Western European capital markets did develop somewhat independently of the US (an example would be France, which is quite different from the US market because of the different basis in law.) Capital markets in Eastern Europe and Asia, on the other hand, were developed based on the US model. (One notable exception is Malaysia where Islamic capital markets are quite well developed.)
However, when it comes to the processes, procedures and even the computer systems that make up the operational infrastructure of global capital markets, the US is the model – they have what we have. Two factors contributed to this state. First, the sheer size of US capital markets made them so dominant that foreign markets found it necessary to build compatible systems. (We are also notoriously slow to adapt to foreign influence: only foreign car specialists use the metric system in the US.) The other factor is the generous nature of the US taxpayer: we financed, via foreign aid, the development of capital markets in virtually every country beyond the G7. I worked in Russia (#8 in the Big G) and can tell you that we refused to give them shorts or stock lending in 1994 because of the known risk factors. [/color]
10) Enron went straight down once the bad news broke – and there was likely naked short selling going on. Likewise, WorldCom and Delta Airlines might be other candidates. All had hundreds of millions of shares outstanding--and if naked selling is as rampant in such situations as many think, then there may have been billions of share 'rights' outstanding when they were de-listed.
Given that the above might be true, do you:. 1) feel these issues would be good targets for a post hoc forensic examination; 2) consider that there is any possibility of success in doing a forensic exam, in demonstrating to what degree naked short selling played a role in their demise; 3) and if so how would you proceed with an in-depth forensic examination, the goal of which would be to lay proof of widespread naked short selling before investors who collectively lost billions, possibly due to the practice.
The primary difference I see in Enron and WorldCom, compared to the NSS cases I’m aware of, is that those companies were heavily “touted”. Did anyone *not* know what Ken Lay and Bernie Ebbers looked like before their companies collapsed? On the other hand, I’m a big hockey fan and I did not know that Melnyck owned the Ottawa Senators before I read the Gradient hatchet job. Also, I’m now convinced that criminal activity was taking place at Enron; I don’t know that we’ll find anything at Biovail that rises to that level.
The forensic accounting for Biovail is pretty straightforward: compare the hatchet job to the financial statements and find the lies. This wouldn’t work on Enron or WorldCom because the lies are in the financial statements.
The share “rights”, “entitlements” or “phantoms” are another matter altogether. The forensic accounting would look the same for every company because it wouldn’t involve their financial statements. [/color]
11) Do you think the DTCC has any valid reason(s) for declining to disclose data and information on the extent of FTDs either as to the market in general, or as to specific companies affected by the FTDs? If so, what is the reason(s)?
From their standpoint, disclosing who failed-to-deliver would be like your bank disclosing details of your bounced checks. Continuing the analogy, your bank is required to disclose certain data that reveals the risks they face (bad debts, for example). In that sense, it would behoove the DTCC to report to someone (whether or not the information is “public”) how much they are owed, by whom and for what in order for real risk analysis to take place. The Federal Reserve Bank (fiscal agent for the US government, the government’s bank, if you will) does disclose aggregate information about the risk in the banking system so why shouldn’t DTCC do this for the capital markets?
As for disclosing FTDs by issue (not by company, because one company could have multiple issues and they are not always easily connected), the analogy to banking fails to provide the answer. The Fed (and hence their member banks) all own shares in the same issue: US currency. (Put aside foreign currency considerations for the moment.) So whatever fail information is disclosed in banking is disclosed on the same issuer.
The question then becomes: what can be gained by knowing which issues are undelivered? (Bringing foreign currencies into the analysis still doesn’t help us because the difference between public companies traded in US capital markets is not as great as the difference between countries when we are measuring risk.) Clearly, as an investor I would like to have those issuer names in my information set because then I’d know how to calculate the actual supply of shares. The parties who are failing to settle know the identity of the issuer; I’m at a disadvantage to them based on information that they not only know but they in fact have (causative) control over. That’s the worst possible scenario for anyone working with a model of perfect capital markets, which requires that information be free and freely available. [/color]
12) Do you view the DTCC's Stock Borrow Program as a tool designed to serve the purpose and motive of naked short selling? Or has it just turned out that way?
The SBP is a large facilitator of NSS. SBP (at subsidiary NSCC and the inverse stock lending program at subsidiary DTC) was not designed to serve NSS. It was designed to reduce risk in the system by guaranteeing delivery of shares to every buyer in the event a seller could not honor its total obligation. While trade-for-trade settlement would leave only a singer buyer at risk for the actions of a single seller, net settlement spreads this risk to uninvolved parties. Therefore, the centralized system required a method, like SBP/SLP, to accommodate fails that made it all the way to settlement date. [/color]
13) In your opinion, what would be the effects (on shareholders, broker-dealers, hedge funds and others) of an SEC ruling that all FTDs be bought in upon expiration of 10 days after the trade?
I believe that there must be a time limit for FTDs, as well as a time limit for stock loans. As I told the audience at the November 29, 2005 forum held by the North American Securities Administrators, there is no such thing as an innocent fail. There is also no such thing as a strategic fail because failing to settle a trade is not a strategy – it is a failure of strategy.
The impact on shareholders would be beneficial – they would get what they actually paid for. Right now, they own phantom shares until the fail is cleared and in the meantime, the broker gets to play with their money for free.
The impact on the broker-dealers would be that they’d have to find a new source for free money, poor things! Seriously, if they’ve become dependent on this source of cash there would be a shakeout in the industry. There is likely a complete lack of knowledge at the retail level that would have to be corrected in order to maintain customer relations under the new paradigm.
The hedge funds should not have major difficulty with this because it is their business to arbitrage risk. Any hedge fund worth its salt would be able to manage under the new system just as well as it does now. How does a hedge fund hedge if the risks are hidden? The best funds should actually flourish under a system where the rules are clearly defined and well-understood.
The impact on others? There will be mass hara-kiri at the SEC and the DTCC before they put a limit on FTDs, so those organizations would need to embark on major recruiting campaigns to replace their fallen leaders. [/color]
14) Why do you think SEC chairman Donaldson chose to answer Senator Bennett's inquiries regarding naked short selling in closed session rather than in public?
Because he knows it’s a problem and couldn’t admit it in public without having his ceremonial knife handy. Because he knows that the problem described by NSS includes the problem of phantom shares, the proxy voting charade and the collapse of corporate governance. [/color]
15) Please elaborate on the companies that are almost completely destroyed by naked shorting especially on the Pinks or OTCBB stocks. I hear rumors of some of these stocks having 2-3 times the outstanding shares being short. Is this rumor true?
Why stop at 3 times outstanding shares? No one has yet proved that there is a limit to the multiplication, though there is a theory that some reporting requirements might stall the process at one month.
Keep in mind that it’s not just that the shares are shorted. It’s also that they are loaned and the loans are not repaid. It’s also that shares are not delivered for the settlement of trades, yet the retail brokerage customer accounts reflect the phantom shares. Economics 101: if you increase supply, you decrease price.
It’s not a rumor, it’s a fact. It’s a fact that the STA and the Business Roundtable have been talking to the NYSE, the DTCC and the SEC about for a decade. Read Drummond’s article in the April 2006 issue of Bloomberg Markets (p.96). Important corporate governance issues, including corporate sales and mergers, are already being controlled by criminal elements. [/color]
16) What is the corporate structure of Cede & Co.? Is it a trust? If it is a trust, where can we find the trust documents? What is the jurisdiction (it doesn't show up on a search for NY companies)? Who owns it? Who are the directors / management. Are securities registered to Cede pledge as security in any way? Why does Cede and its assets not show up in the DTCC annual report?
There is no trust company named Cede, no “company” in fact named Cede. Cede & Co. is a nominee name. It originated in the acronym CD which stood for something like central deposits, which was the name of the department at the NYSE that was the predecessor to the DTC which is now a subsidiary of the DTCC. You should simply look for Depository Trust Company. Shares registered to Cede & Co basically belong to the Participants who have shares on deposit there. [/color]
17) If a US participant buys from the Canadian Depository for Securities, does the trade always fail? The CDS position size will stay identical on position reports over time (once you net incoming / outgoing certs. into CDS). That seems impossible. Shouldn't some trades go into Canada or out of Canada? The only solution I can see is that shares deposited in Canada stay in Canada, even if the Canadians sell to Americans. Otherwise the security position report should show this account fluctuating wildly.
It seems that that is where much naked shorting comes from. The US participant goes "where are my shares?" and they say, "don't worry about it, they're in Canada".
CDS is the DTC of Canada, so DTC participants buy from CDS participants (not from CDS). Each depository has an account at the other depository that looks, for all intents and purposes, like another participant account. When I was with the Pacific (see “First Series of Interview Questions”), we had an account at DTC which was used for inter-depository settlement. So when CDS participants trade with DTC participants, there is a net settlement position for shares and cash between the two depositories that is settled out each day. The shares are always left in place, physically, for the sake of “immobilization.” Periodically, shares are withdrawn from one depository and re-registered for delivery to the other in order to manage the local inventory of share certificates. I remember once getting a panicked call from ITT when they say a massive movement of shares from Chicago (Midwest depository) to Cede – they wanted to know who in NY was buying up their shares and were they mounting a takeover attempt. The reality was that DTC was doing a drawdown of inventory from the Midwest, nothing more. [Well, maybe a little more. It turned out that DTC was doing the drawdown in anticipation of the Midwest depository closing down.]
Trades done with CDS participants do not always fail. I’ve forgotten the specific account names, but there should be a separate CDS account at DTC to reflect inventory (versus the position left behind after settlement). It’s when the inventory and the position diverge substantially that certificates are usually re-registered and moved.
While there are differences in the short selling rules in Canada that can create problems beyond what we already have in the US, it is not necessary to have trades with Canada to generate phantom shares. [/color]
18) Am I correct that the NSCC obligation to deliver shares to the net long participants is independent from the net short participant's obligation to the NSCC? In other words, if the seller flees, wouldn't the NSCC be on the hook for the shares?
The NSCC does put itself in the middle, so to speak, of every settlement obligation. In that sense, if any participant walks away from any obligation, the NSCC is on the hook. Their first line of defense is the participant fund, to which each user contributes an amount which is based on their activity. [/color]
19) I had drinks with a person who is expert in clearing on Friday. He said Patrick should do a rollback (he could always do a forwards split later) and change his CUSIP number. Is my friend right that this would force the system to reconcile all the claims into real shares?
No, your friend’s suggestion would most likely result in the issue being frozen at DTCC. Then not only can they not withdraw certificates, they won’t be able to make book-entry deliveries either. [/color]
20) How can any stock holder be sure he's holding genuine shares, as opposed to counterfeit? (Certificate holders excepted, of course.)
Direct registration: no certificate, electronic access to the market and you are registered with the issuer. Unfortunately, according to the Securities Transfer Association, the electronic access portion is poorly developed at the broker level; there is little or no training at the retail level; and the costs are borne entirely by the issuer. But if you have direct ownership, on the books of the issuer, there can be no question of your genuine shares. [/color]
Copyright ©2006 Bob O'Brien