After a market crisis, there is typically a backlash against selling stocks short especially when prices have declined. But there is an important difference between naked and covered short selling.
One practice contributes to market instability and stock market declines: the other is a legitimate function needed for a liquid market.
Naked short selling of stocks arises because there is no cost for failing. In the fixed income markets, however, there is a daily cost for being short.
During the height of the banking crisis last year, the Treasury Market Practices Group instituted a charge for failing securities. This should be the model for the stock market.
Short selling is when a trader sells a stock he or she does not own now with the intent to buy it later- presumably at a lower price. To do this, the short seller borrows shares from someone who owns them, generally the stock loan desk at a major bank or brokerdealer. When the trader buys the shares, he or she returns the stock to the original owner. This is a legitimate market activity that creates liquidity, price discovery and an efficient market.
However. naked short selling is when the trader does not borrow the stock but sells it anyway. When settlement day comes, the seller has nothing to deliver and the stock -fails.”
Naked short selling has two serious market consequences. First it generates fails in the stock. These create settlement problems, regulatory capital charges and unwanted credit exposure. Second, naked short-selling inflates the supply of the stock and puts downward pressure on prices.
FIXED INCOME MARKETS
The difference between short-selling in the equity markets and in the fixed income markets is the cost of carry. In most stocks, there is no cost for being short. If there is, it is a dividend payment paid only four times a year. But the fixed income markets have a daily cost.
Fixed income (e.g., a bond) generally has a coupon: interest paid to the owner twice a year, but it accrues daily. If you are short the asset you have to pay the accrued interest each day.
When calculating the cost of holding a U.S. Treasury, a trader figures the daily coupon accrual versus the cost of financing that security in the repurchase (repo) market: how much the security earns versus how much it costs to borrow the cash to pay for it.
If the coupon is 5 percent and the repo rate is 4 percent the trader can generate a 1 percent annualized rate a day owning the security. If the repo rate is 0 percent, the trader can make 5 percent carrying the security each day.
A trader short the security pays the 5 percent coupon. If it costs 4 percent to borrow the security in the repo market it costs the trader 1 percent to be short.
If there were a shortage in a security, and the repo rate is at or close to 0 percent, problems arise. Traders have little incentive to cover short positions because no interest is being earned on the reverse-repo. For a 0 percent repo rate, you receive no interest just the same as if you do not cover your short. So when repo rates approach 0 percent fails begin to increase.
During the banking crisis last year, the U.S. Treasury market developed a significant fail problem. Many U.S. Treasury securities were purchased in a flight-to-quality and sold to investment portfolios. These portfolios did not loan them back to Wall Street and there was a shortage of many U.S. Treasuries. Repo rates declined to 0 percent. Some dealers preferred not to cover short positions at all and just failed. Fails in Treasury securities (total fails-to-receive plus total fails-to-deliver) reached a peak of $5.3 trillion Oct. 15, 2008, according to the Fed.
Fails began to decrease as the banking crisis subsided. but the problem was further compounded when the central bank eased the Federal funds target rate to a range of 0 percent to 0.25 percent Dec. 16, 2008. The entire repo market began trading at rates close to 0 percent. There were virtually no costs for failing any U.S. Treasury. By the end of the year, fails were still high at $757 billion.
The Treasury Market Practices Group, under pressure from the Federal Reserve and Treasury Department developed a solution. The group initiated a daily charge for a fail. The Fed uses a formula to determine the charge. As of Oct. 7, the charge is a 3 percent annualized The Official Advocate for Personal Investing 19 rate. Most repo rates are still close to 0 percent, but there is a greater cost for failing deliveries.
The fail charge began May 1 and has been extremely successful. Fails were only $24 billion on Sept. 23. Traders are more diligently covering shorts. and some securities even trade at negative rates. The fail charge has reduced fails. and created better liquidity. price discovery and a more efficient market.
STOCK MARKET SOLUTION
The stock market should institute a similar fail charge. It would mainly affect
naked short sellers. Because they do not own the stock and have not borrowed it, they fail to their counterparties. Naked short sellers would be forced to pay the fail charge.
Once there is a greater cost for failing, naked short selling will become much less attractive and significantly reduced.
As the Securities Exchange Commission is looking at ways to regulate short selling, the best solution is to create a cost.
The SEC initiated a rule last summer – Rule 204T – which requires broker-dealers to cover failing short sales by borrowing securities or buying the positions after four business days. The rule has decreased the number of open fails in the equity markets and acted as a determent to naked short selling.
I recommend that the SEC go one step further and implement a fail charge for stocks. The U.S. Treasury market did it successfully this year and can server as a model for the equity markets.
Instead of new short selling rules and regulations, the SEC should target the bad practice of naked short selling without affecting legitimate covered short selling. A fail charge is one of the best ways to accomplish this.