Thursday, September 27, 2007

Reforming the Stock Loan Quagmire

New York Times chief markets correspondent Floyd Norris has a particularly savvy and thought-provoking column today on reforming the grimy, scandal-wracked stock loan business. The approach outlined in the column toward the much-exaggerated "naked short selling" issue, a subject of much wasting of resources by the SEC, is particularly interesting.

All short-selling depends on stock loans, and that is a disreputable business. Last week, federal criminal charges were brought against stock loan officials at major brokerages, essentially for preying on short sellers. What's bad about that is that shorts add liquidity to the market, and are a major counter-force against stock market hype and corporate sleaze.

Quoting a prof named James Angel -- who interestingly is a darling of the anti-naked shorting conspiracy types -- Norris makes the following observation:

If the stock-loan market were transparent, then it would be clear how much money a trader who failed to borrow shares was saving, argues James Angel, an associate finance professor at Georgetown.

"The problem won't go away," he said this week, "until the economic incentives are fixed."

Angel has suggested that the SEC drop its complicated regulations on the subject, known as Regulation SHO, and simply tell stock markets to levy fines for violations that would be higher than the costs the traders avoided. That would, he thinks, end the problem of naked short selling.

There would still be some failures to deliver, caused by paperwork problems, but they would be relatively rare.

It is not that simple, as he concedes.

Moving to such a rule could lead to short squeezes in the form of sky-high borrowing costs, which could amount to stock manipulation on the upside, and he says it might be a good idea to put a cap on the fee.

He would also like the SEC to take steps to make more shares available for lending, by allowing brokerage firms to lend out shares held in all customer accounts, not just margin accounts.

Of course, no approach would stop the constant conspiracymongering about naked shorting. Since this is a nonexistent problem, there is, by definition, no solution. But opening up shorting to non-margin accounts would make it harder to engage in manipulative short squeezes, while also dealing with naked shorting. I think it is worth a closer look.

© 2007 Gary Weiss. All rights reserved.

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