Every day Australian stockbrokers are phoned by the ASX around 11am and asked if they wouldn’t mind, please, just withdrawing that buy order they made three days ago, because it’s not going to settle today and the CHESS system has to balance at midday each day.
Under the T+3 settlement system, sellers have three days to provide stock to the buyer (and the buyer has three days to cough up the cash).
Brokers believe the reason there are failures to settle virtually every day is that hedge funds are gaming the ASX fines with “naked short selling”.
That is, they are selling short, but not borrowing the stock in time to meet settlement in three days as required.
That’s because the fine for failing to settle is 0.1% of the amount outstanding, with a floor of $50 and a maximum of $2000.
With almost every trade it is much cheaper to pay the fine than to borrow the stock from a securities lender, so naturally hedge funds just pay the fines. There are no other consequences – it is, for them, just a cost of doing business.
For the buying broker it is more than irritating. If a broker buys shares on behalf of a client but does not deliver the scrip in three days, it must give the client’s money back. There is no choice in this and it comes off the broker’s capital. One day a small broker will go to the wall because a big order did not settle.
The buying brokers all agree to remove their orders from CHESS each morning because they know there is no point rocking the boat, and because they know they’ll probably have a non-settling hedge fund as a client next time, and they’ll be making the phone call. Some small brokers, however, don’t act for hedge funds and therefore don’t sell short.
This is the ASX’s dirty little secret. It is collecting transaction fees on pretend transactions that never settle.
The fact that this is called “naked short selling” and made to sound kind of official and okay, along with “covered short selling”, is beside the point.
Terry McCrann wrote in the Weekend Australian on Saturday that naked short selling should simply be banned, no ifs or buts. Selling something you don’t own or haven’t already borrowed is fundamentally incompatible with market certainty and timed settlement.
He’s probably right, although it is possible legitimately to short sell “naked” – it happens all the time. And the regulation of covered short selling is a mess as well.
The ASX has called for consultation on the issue of short selling, but this is mostly about the fact that covered short selling is totally undisclosed. That’s because the stock is borrowed before the sale, not after.
Naked short selling that does not involve a breach of T+3 simply means borrowing the stock between the sale and the settlement. If the plan is to buy stock to cover a short sale a day or two after the sale, rather than borrow it, then T+3 means you will be late in settling because the person selling it to you will take three days to deliver it.
Borrowed stock does not operate on T+3; when you borrow it from a lender’s inventory, you get it immediately.
If someone sells short with the intention of borrowing the stock before settlement (that is, they’re “naked”) it must be disclosed. But if someone borrows the stock before putting in the sell order, then it need not be disclosed because it’s “covered” – that is, they own it.
And by the way they really do “own” it – the AMSLA, or Australian Master Securities Lending Agreement – confers full title to the stock on the borrower, as clients of Opes Prime have discovered to their dismay. It turns out they lent their shares to Opes under an AMSLA to secure their loans, rather than mortgage them.
That is a whole other can of worms, but short selling – naked or covered – is an absolute joke, and an indictment on the ASX.
If it’s naked short selling and the ASX is simply fining hedge funds that knowingly fail to settle $2000 a day, then the ASX is itself knowingly participating in a rort.
If it’s covered short selling, that is where the stock is borrowed before the sale but the seller is not disclosing that it’s short, then the ASX is knowingly participating in another rort – non-disclosure.
Either way no “consultation” is needed; the ASX just needs to clean up its act, or lose the business of regulating the market.
This story first appeared in Business Spectator