Tuesday, November 07, 2006

The Emperor's Clothes

The discussion of naked short selling is continued from the last post, “Peter and Paul.” I have returned to this topic several times, not so much because I have evidence that it is a crime running rampant on Wall Street, but because that is the perception.

I note that neither government nor industry regulators have moved for an outright ban on naked short selling. Instead they have focused their efforts on monitoring the worst violators that appear to be engaged in abusive and manipulative schemes. To me, this is sort of like the ministers in the eighteenth century fairy tale, The Emperor’s New Clothes. They inspected the empty looms run by swindlers posing as tailors, but for fear of being thought stupid, the minister’s reported back to the emperor that they saw “magnificent patterns and colors.” The Emperor appeared in court naked as jaybird, head held high, but in the end I do not think the Emperor regard his trade as fair.

The idea that regulators might be looking at empty looms and coming back with glowing reports of “magnificent patterns” is fostered by a review of the stocks on the so-called
Regulation SHO Threshold Security List. The exchanges are required to publish lists of equity securities for which failures to deliver shares against sales have hit “threshold” or minimum levels.

Clearing firms suggest there are a number of structural impediments to delivery that represent a legitimate failure to deliver. If that is the case, one would expect to see a good number of the stock universe on the list at one time or another. However, so far it appears that most securities are never on the list and some securities are such “frequent flyers” it cannot be attributed to structural impediments. In other words, the looms really are empty.

In my view, it is a legitimate function of regulators to smooth out the playing field for all market participants and make certain everyone follows the rules. That there are so many companies so appearing so frequently on the Threshold Security List suggests that either the playing field is uneven, some payers are cheating or both.

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