Wednesday, July 30, 2008

Getting Naked

An interesting conversation with a NY friend shed light on the new shorting rules from SEC chair Chris Cox. My friend works for a market maker in research (and does fascinating work, which will be the subject of a future post). Although there has been a lot of noise about "Naked Shorts", he explained that the term is overused. For lack of better terminology, we started talking about the difference between being "Naked" and being merely "Nude".

Being "Naked" was, is, and always will be illegal. It is the creation of shares out of the void, so that the seller fails to deliver within a specified time. The ability to arbitrarily create shares would naturally result in CEOs selling 400% of the total outstanding shares, pocketing 300% of the proceeds while driving the company into bankruptcy, and then fleeing to Tahiti with as naked a trophy wife as the local laws will allow. If you've seen The Producers, you are already familiar with this business plan.

Being "Nude" has always been legal. This shorting comes in two flavors: Locate and Pre-Borrow contracts. The Locate contract is understood to be a short-time borrow of the shares. The shares absolutely can be located upon demand, but a demand is rare because market-makers only need the shares for a grand total of about 10 minutes. Pre-Borrow means that the shares are reserved for 24 hours.

The nature of the recent SEC regulations is that "Locates" are no longer allowed, so that market makers must arrange for Pre-Borrow shares: They must also pay the associated overnight rate, which is substantially higher than borrowing for 10 minutes. Naturally, those who are lending out the shares are quite pleased by the extra fees, but the market makers see it as additional cost and are loudly complaining to anyone who will listen.

The net effect of the rule is that market makers will allow the price to swing by larger amounts in order to make up for the difference. This additional volatility will not cause just greater upswings, but also greater downswings. I doubt that the SEC has fully prepared for the law of unintended consequences.

In summary: Naked is like pornography for Cox, and he knows it when he sees it. So stick to getting Nude, which is far more artful.

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