When you have the opportunity review The Depository Trust & Clearing Corporation (“DTCC”) website found at www.dtcc.com. There is a plethora of information, most of which is very interesting. Excerpts of selected articles pertaining to how the DTCC handled short sale exceptions and an annual operational review letter are discussed below. To add a little levity test our intelligence on the DTCC Matching Quiz following this discussion and discover just how intertwined the securities industry is.
The first article, one submitted in early 2003, addresses the “alleged short selling” of issuer’s shares. Relating to companies who sought to remove themselves from being held hostage to the policies of The Depository Trust Company (“DTC”), a subsidiary of the DTCC, the following statements were released:
· The rules governing short selling are the same in a physical environment as they are in a book-entry environment. Moving to physical securities does not inhibit short selling in any way. The rules governing short selling are the same, and are made and enforced by the SEC and major markets. Those are Rule 3370 for NASD members and Rule 440B for New York Stock Exchange members.
· DTC rules do not allow its participants to be short in deliveries to other participant firms. While a brokerage firm can lend shares to an investor, the brokerage firm cannot be short in delivering shares to another brokerage firm through DTC. If necessary, a firm can and must borrow shares from one or more brokerage firms that currently have enough shares in inventory to lend. Brokers who fail to deliver shares owed at DTCC are subject to penalties.
In a following footnote, the DTCC goes on to state that, “an investor borrows stock certificates for delivery at the time of short sale. If the seller can buy that stock back later at a lower price a profit results; if the price rises, however, a loss results.” In continuing to describe the interaction, the DTCC in the next paragraph continues with:
Loans of shares can be made by a broker from his own inventory, from the margin account of another customer, or shares borrowed from another broker. These shares are used to make settlement with the buying broker within three days of the short sale transaction, and the proceeds are used to secure the loan. “Naked short selling” is alleged when securities are sold short but neither borrowed nor never delivered.
This article was written in 2003. Not once did the article address the naked shorting issue other than to call it an “allegation”. Never once did the term “locate” come into play nor did an explanation of what the “penalties” would be for a failure to deliver. I guess they could have added the statement “if your broker or another brokerage firm through the DTC is unable to lend shares have no fear, we’ll just print more.” As noted by the date of the article, problems were known to exist as early as this period in time, more than five years ago.
See: http://www.dtcc.com/news/press/releases/2003/nakedshorts.php#1
In a second article, the DTCC discusses its Continuous Net Settlement (“CNS”) System. The CNS is an automated book-entry accounting system that centralizes the settlement of compared security transactions and maintains an orderly flow of security and money balances. Later in the article, it addresses short transactions with two separate sentences:
· While deliveries between CNS and users’ depository positions are made automatically, participants can exempt certain short positions (or portions thereof) to avoid segregation violations and effectively meet other delivery needs.
· CNS short positions, which represent securities owed by participants to NSCC, are compared against their DTC accounts to determine issue availability. If shares are available, they are transferred from the member’s account at DTC to NSCC’s account at DTC to cover participant’s short obligations to CNS. To control the automatic delivery of securities from their DTC accounts, participants can use CNS exemption procedures (partial settlements are permissible).
· The Stock Borrow Program enables participants to lend excess securities in their DTC accounts to CNS so that NSCC can satisfy delivery obligations not filled via normal deliveries.
Not once in this article did the DTCC address or imply that there could be failures or exceptions made on the long side of the transaction. It seems that every opportunity to exempt or alleviate difficulties associated with short sales is available throughout the clearing system but not to the counter side of the transaction. In addition, no effort to define the term “temporary” is even attempted.
See: http://www.dtcc.com/products/cs/equities_clearance/cns.php
In a third article, the DTCC discusses its Stock Borrow Program which allows participants to lend NSCC available stocks from their account at the DTC to cover temporary shortfalls in NSCC’s CNS System spoken of in the last paragraphs. This article addresses the function of the Stock Borrow Program the operation of which, in and of itself is an exception. An understanding of the process is therefore important.
The Stock Borrow Program enables participants to earn interest on the full current market value of their excess DTC positions borrowed by NSCC, while lending securities in the safety of a controlled environment.
· In the Stock Borrow Program, participants' NSCC money settlement accounts are credited on the day of the loan with the full market value of any securities borrowed by NSCC. This allows members to invest the funds to earn interest overnight on the value received from the loans.
· Securities on loan to NSCC are recorded as long positions in a special CNS account set up specifically for the participant's Stock Borrow activity. This enables the member to benefit from lending securities within the safe, controlled CNS processing environment
After NSCC borrows securities the transactions are recorded as long positions in the participant's Stock Borrow sub-account, a special account in the CNS System. The total current market value of the borrowed securities is credited in the participant's CNS account. These funds are available to the participant overnight. This process is reversed when NSCC returns the borrowed securities. No rebates are charged and the entire transaction occurs in the controlled CNS processing environment.
NSCC distributes reports to participants each morning, reflecting Stock Borrow activity. In reviewing the report, participants sometimes discover that the securities lent to NSCC are needed for customer securities segregation requirements. In such cases, at the request of the participant, the long position in the Stock Borrow account is moved into a long position in the Fully-Paid-For (E) account. This results in the member not being credited the current market value of the securities position. The Securities & Exchange Commission treats this "E" position as a good control location for customer securities under Commission rule 15c3-3.
Again, let’s take care of “shortie” seems to be the overriding emphasis of the article. You have to start to wonder why they complicate the obvious; obtain a firm “locate” before shorting a security, instead of making up rules to complicate what would be a simple transaction. They have rules to cover rules when it comes to the “dark side” of the trade. They know they have a problem, one that has essentially taken on a life of its own, due in part to the manner in which the DTCC addressed, or failed to address it. Remove the opaque disguise, illuminate the problem and let the markets function fairly. Oops, I forgot, that would cost every participant on all side of the trade money, how silly of me.
See: http://www.dtcc.com/products/cs/equities_clearance/sbp.php
As expected from any organization audits complete with cover letters and opinion statements relating to them are commonplace. On December 31, 2007, the DTCC issued “Management’s Statement Regarding Internal Control Over Trade Comparison, Netting and Settlement of Products Services by NSCC”. Signed by DTCC Chairman Donahue and President Aimetti, the letter discusses the responsibilities of the NSCC as they pertain to effective trade clearing with averments to the following qualification:
“Even effective internal control, no matter how well designed, has inherent limitations – including the possibility of the circumvention or overriding of controls – and therefore can provide only reasonable assurance with respect to trade comparisons, netting and settlement. Further, because of changes in conditions, the effectiveness of internal control may vary over time.”
As is also standard, these letters are accompanied by a statement letter of the auditing firm. In the PriceWaterhouseCoopers letter, signed by the auditing firm, the following is found:
“Because of inherent limitations in any internal control, misstatements due to error or fraud may occur and not be detected. Also, projections of any evaluation of internal control over trade comparison, netting and settlement of product services by NSCC to future periods are subject to the risk that the internal control may become inadequate because of changing conditions, or that the degree of compliance with the policies or procedures may deteriorate.”
The DTCC is admitting that there are problems that are simply “out of their control” which could lead to the effectiveness of their clearing functions being compromised. In case you wondered, a recent new addition to the Board of Directors comes to the DTCC directly from the PriceWaterhouseCoopers. I guess they liked the disclaimer.
See: http://www.dtcc.com/legal/internal/2007_nscc.pdf
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