June 22, 2004

DTCC accused of counterfeiting shares

I had heard about Stockgate a while back when the Nanopierce lawsuit was filed. At the time, it looked like a hopeful settlement deal, but now more details have come to light [1].

And what details! This may well be bigger than the mutual funds scandal, which was the biggest scandal of all time as far as I can see. The Nanopierce class action team has 65 lawyers in it! They have (allegedly) uncovered 1200 funds and 150 broker dealers in naked short selling.

Here's how it works. Short selling is supposed to involve borrowing the stock, then selling the borrowed stock on the market, anticipating a drop in price. It's "good" because it moves information more quickly. It's "bad" because someone with a lot of time and money on their hands can just dump the stock and then buy it back at a cheaper price. Like all things valued by people over the age of 12, there are goods and bads in it.

Where it gets egregious is if the stock is not borrowed at all, and simply "sold" on a promise. Now, if you are a big bad player and you can "not borrow" enough of it, and "sell" enough of what you don't have, then the price has to go down. Supply and demand, and all that. Then you can "buy" it on the cheap, transfer a few things around in the accounts, and end up with a profit.

Having the actual stock on hand is supposed to put a brake on this practice. And, when the DTCC - the single depository and clearing agency in the US - set up its stock lending facility, it was quite popular, as it was relatively easy to just borrow the shares from DTCC, and dump them on the market.

All supposing that DTCC had acquired them from somewhere. Now it transpires that DTCC took a fee for this activity, and worked out that they could over-lend. That is, they could simply counterfeit the shares. It's alleged by the lawsuit that DTCC turned off its governance, and turned on the equity tap. Anyone who wanted to borrow, presumably could - even if there were none to borrow.

"The Stock Borrow Program was purportedly set up to facilitate expedited clearance of stock trades. Somewhere along the line, the DTCC became aware that if it could lend a single share an unlimited number of times, it could collect a fee each time, according to Burrell. "There are numerous cases of a single share being lent ten or many more times," giving rise to the complaint that the DTCC has been electronically counterfeiting just as was done via printed certificates before the Crash."

"Such re-hypothecation has in effect made the potential 'float' in a single company's shares virtually unlimited and the term 'float' meaningless. Shares could be electronically created/counterfeited/kited without a registration statement being filed, and without the underlying company having any knowledge such shares are being sold or even in existence." ...

But, says the cunning governance observer, what happens if the price moves against the naked short seller? Surely he's then caught with his pants down? No. Here's the game: DTCC, instead of taking a clearing agency role as they are supposed and covering the particpants, simply refers the dispute to arbitration between the parties! And, they leave an open position book until it has been resolved.

If true, this makes a mockery of governance, regulation, the system, and any sense of investment. What is the point in investing in shares in a small company if the big players are naked short selling it out of existance, simply to transfer wealth from your pocket into their pocket?

The mutual funds scandal was pretty rude - big players conspired with insiders to strip out percentage points worth of value every year. This sort of salami scam works as long as the amounts taken out don't appear too large. 1% per annum is fine ... always remembering that we are talking about 1% of a 7 trillion dollar amount here.

But stockgate is a whole other ballgame, as the Americans would say - here, broker dealers and investment banks were conspiring allegedly to transfer the *whole* value of small companies to them. One expert claims that 7,000 public companies and from one to three trillion dollars have been raided.

[1] http://www.investors.com/breakingnews.asp?journalid=21660437&brk=1
StockGate: London Companies on Berlin Exchange Ask for Investigation, Reg SHO Hearing Reset

Posted by iang at June 22, 2004 07:26 AM | TrackBack

Even if I don't understand half of the business terms it's still enough to make me pick up my jaw from the floor where it fell.

Posted by: Axel at June 22, 2004 10:13 AM

Yeah, it doesn't just drop the jaw, it sends it skidding out the room...

Perhaps I should explain the context ... Financial Cryptography systems have pretty much solved the problems shown in Stockgate and Mutual Funds scandals. Yet, implementing systems with FC faces huge institutional barriers, not the least of which is that opportunities to make money out of the system's ropiness are somewhat lost.

Meanwhile, scandals keep coming. One estimate of the mutual funds scandal has it at half a trillion dollars, and this Stockgate thing is coming in over a trillion in lost and stolen money. A trillion here, a trillion there, pretty soon you're talking real money.

Posted by: Iang at June 22, 2004 11:11 AM

Further info on the scam has come to light on how the cycle works. I can't be bothered to write the details right now, but it can be basically limited to the PIPE market. This means that the amount raided is probably in the billions, and wouldn't come close to the trillions suggested above by some observers.

Posted by: Iang at June 25, 2004 07:02 AM

How does this get rectified? Who is investigating this problem? What is the SEC doing? Are they even aware of the problem?


Posted by: John Valentino at June 30, 2004 12:31 PM

There is only one solution that is "real" and that is RTGS. That won't happen any time soon. In the meantime, expect the system to limp along and hope that nobody gets too greedy, because that's when firms start failing.

The SEC can't do anything, but they are certainly aware of the problem. It's caught between an outraged congress, an apathetic public, the powerful vested interests of trillion dollar money managers, and an impossible mission.

None of that is going to change either, but the real thing that needs to be done is to change the mission, which was some socialist objective set after the crash of '29. Until that happens, expect the SEC to get forced into more and worse regulation, in order to appear to be meeting its congress-mandated goals.

Posted by: Iang at June 30, 2004 12:57 PM

Well, the unreconciled difference with DTC is easily taken care of since the shorts come home to roost eventually. So when they do they can be applied and netted away. It is of course illegal to do this type of operation and many of the technical aspects of how it is done are not clear, nor will they be made clear.

The simple matter that the pump and dump stocks complain about - the naked short sellers - is taking the attention away from their own robbery of shareholders via dilutive transactions that make suspect use of funds like PIPEs.

There is another area of play not taken into consideration which is the Contracts for Difference Markets of London that basically allow synthetic shorts to be placed without regard to US short sale rules or stock loan requirements. I suggest the Deep Throat suggestion of follow the money is the answer; the PIPE transaction, ie convertible debt issuance via a privately negotiated transaction, is the root of the problem since it allows for the closing of the short positions. The average Hedge fund that does PIPEs makes between 10 and 25% on their funds per year and it is a safe bet to make.

Posted by: Jim at June 30, 2004 01:49 PM

The PIPE products and the DTCC seem like separate issues to me. The intelligent course would be to dump the DTCC and find a path to RTGS but I wouldn't hold my breath. Until this happens anyone who invests in Equities is out of his mind.

As far as PIPEs are concerned, any board that makes such an issue should be kicked out, hard, by their shareholders. There's no such thing as governance at the individual firm level either.

Of course the answer will be more regulation. What do you expect when you ask regulators to solve a problem for you? We already have an economy that is floated on fiat currencies; why not go one step further and legitimize the DTCC into a Fed-like foundry for the fabrication of imaginary equity?

Posted by: Steve Wart at July 2, 2004 03:47 AM