A curious thing happened during Uber’s troubled initial public offering last week: naked short selling of UBER shares by the banks involved in placing Uber’s IPO, according to several sources who confirmed this to CNBC.
Normally, naked short selling is illegal. But it was legal in this case, and it gave the banks a chance to profit–as investors lost money–when the IPO traded down 18% in its first two days (see here, here and here).
What’s the rub? Naked-shorting of IPOs by banks, which the SEC green-lighted as recently as 2015, has changed IPO market dynamics by altering the relative power between banks, issuers and investors. To the detriment of investors, banks now have less fear of incurring major losses from pricing an IPO too high because banks now have a tool (naked shorting) to protect their downside risk.
The SEC explicitly gave banks a green-light to naked-short securities that are subject to underwriting commitments, such as IPOs. It revealed this in a Q&A about Regulation SHO (available here, Question 1.5).
Previously, banks lived in fear of overpricing an IPO because they could–and sometimes did– lose big money if the stock traded below its IPO price. IPO underwriting used to be a high-risk, high-reward business for banks–offering a lot of upside but also the potential for ugly, ugly downside. But that’s not so true anymore. Thanks to the SEC’s explicit statement allowing naked shorting during IPOs, banks now have a chance to win regardless of outcome. When the IPO goes well, banks pocket big underwriting fees without trading losses. When it doesn’t go well, banks can still pocket big profits–but the profits come from the trading side, because naked shorting allows banks to profit from the declining stock price. (Naked shorting means the bank can satisfy real demand for the stock by selling phantom supply, which the bank can conjure out of thin air. This suppresses the stock price, owing to simple supply/demand dynamics–because as supply goes up the price drops, holding everything else equal). To be clear, banks’ profits are not guaranteed in these situations but the odds are shifted firmly in the banks’ favor. It’s a “heads the bank wins, tails the bank is still likely to win” dynamic. With those odds, decent traders at the banks will make money most of the time.
But IPO investors don’t have any such downside protection.
IPO pricing has always been more of an art than a science–a tri-party negotiation between issuers and investors, with banks putting their capital at risk to bridge the gap (including stabilizing the stock once it begins trading in the aftermarket). In my experience, which is direct but not recent, IPO pricing negotiations often turn heated–there’s inherent tension, since issuers will always want to sell high and investors will always want to buy low. In the tug-of-war, banks used to draw the line more toward the side of investors because the banks could lose big money if they caved to pressure from issuers and priced the IPO too high. But today, banks now have an SEC-authorized tool to manage their downside risk.
That means banks have a lot less incentive to stand firm when issuers push them to set IPO prices too high. The upside/downside probabilities for IPOs have changed.
The troubled performance of recent large IPOs must be a disappointment to the SEC, whose Chairman Jay Clayton explicitly set a priority of his tenure to coax more companies into the IPO market and out of private ownership. The number of publicly-traded companies in the US has declined by almost 50% since its peak in 1996. There are myriad reasons why this has happened–private companies have better access to capital than they used to, publicly-traded companies face much higher compliance costs relative to private companies, and companies open themselves up to greater lawsuit risk when they’re publicly-traded (“everything has become securities fraud”). The SEC has taken several steps to try to fix this and make capital markets fairer to regular folks.
Ironically, the SEC’s explicit green-light of naked shorting for underwritten securities may have had the opposite effect and inadvertently hurt investors.
So, what does any this have to do with blockchain?
Answer: Naked shorting is impossible to do when securities are issued natively on a blockchain. Had Uber’s shares been issued on a blockchain rather than through legacy systems, banks simply would not have been able to issue more UBER shares than the quantity of shares outstanding. The price-suppressive impact of the naked shorting–however large or small it was in the Uber case–simply could not have happened. And, had the banks had no way to protect their downside risk by naked shorting, one can only guess how much lower Uber’s IPO price might have been.
How Is Naked Shorting Even Legal?
The fact that naked shorting of stocks is legal at all is a vestige of history–of outdated US laws, which themselves simply codified a market structure for US equity markets that has also become outdated.
It once made sense for securities to be owned indirectly (instead of in the owner’s name), just as it once made sense to insert layers of intermediaries into settlement processes to minimize the quantity of transactions that firms settled with each other (today, firms add up debits and credits, net the amount, and settle only the difference). Technology limitations once dictated this market structure–and precluded same-day settlement of securities trades.
These technology limitations have long ago been solved. Yet, the old market structure remains.
If we were re-designing equity markets from scratch, they would look nothing like they do today–and they would be much more investor-friendly.
If the SEC doesn’t address the problem, there’s another group that could–and on this front there’s good news. The Uniform Law Commission, which coordinates Uniform Commercial Code drafting, has formed a joint study commission to review the impact of emerging technologies on the UCC and possibly draft amendments or revisions to it. As currently drafted, UCC Article 8 enables naked short selling. Consequently, the joint study commission has an opportunity to fix the problem at its origin.
Naked shorting was enabled legally by UCC Article 8 in 1994, owing to a combination of two features: (1) indirect ownership of publicly-traded securities and (2) a special exemption that obviates the normal requirement that the seller prove in advance that it actually owns the property it is selling to a buyer.
Regarding the indirect ownership feature, most of us believe we own securities in our brokerage accounts but that’s not the case. What we actually own is an IOU from our broker-dealer–a contractual right to the shares instead of the real thing. Your broker, in certain circumstances, has the right to conjure and sell you IOUs to more shares than actually exist.
That’s where the second point comes in. Before buying a house or a car, for example, the seller must prove to you that it owns valid title. But that’s not true for securities, which have a special exemption from this requirement. Section 8-501 of the UCC allows securities intermediaries to credit “security entitlements” to a customer’s account without regard to whether the securities firm actually holds the securities. In other words, yes, it’s legal under the UCC for your broker to sell you something it doesn’t own. Section 8-504 attempts to mitigate the dangers of “overissue” of securities by requiring securities firms to hold a sufficient quantity of securities to satisfy all customer claims–but buried in SEC rules are myriad loopholes that enable securities firms to “overissue” securities (such as naked shorting of IPOs, operational shorting by ETF market-makers, rehypothecation, failures-to-deliver, the Customer Protection Rule enabling debits not always to equal credits, and other examples).
Regarding the “overissue” problem, securities settlement expert DC Donald aptly wrote, “Imposing strict standards on intermediaries can reduce this problem, but not ultimately eliminate it. The problem is a price the market pays for making claims against a number of different intermediaries’ holdings negotiable.”
In other words, the US legal system made a policy decision to favor liquidity over solvency–to favor negotiability of securities over keeping accurate and timely records of who really owns what.
The problem, as Uber investors have just learned the hard way, is that “overissue” of securities suppresses market prices. This is one of many subtle ways that value is skimmed from Mom and Pop investors in securities markets.
To be sure, naked short-selling has been controversial for years and the SEC has made huge strides in shutting the practice down since beginning to tackle it in 2005. But in 2015 the SEC explicitly left a large loophole for banks to engage in naked-shorting of IPOs. This has shifted the upside/downside odds for IPOs in the banks’ favor. It’s not a healthy dynamic for the IPO market, nor for fair capital markets generally.