T+2 settlement is not a good deal for investors
Executive Summary: T+2 settlement days serves short sellers well by providing shares for them to borrow, and it serves brokers well by encouraging clients to open margin accounts that enable brokers to lend shares earning high double-digit annual rates of return, but T+2 is not a good deal for consumers, whose shares end up working against them because of a flagrant conflict of interest at the trusted custodian. Is there any wonder why T+2 has remained despite technological advances that could have obsoleted it years ago?
Gamestop Post-Mortem (1050 words)
The Gamestop fiasco could have brought the US financial system to its knees if trading had not been stopped. Short-sellers unable to find enough shares to cover their positions faced potentially infinite losses, and the clearing houses were on the hook for it. The incident lays bare the problem and what should be done about it.
Fifty years ago, it took five days to clear a trade on the stock market. Messenger boys delivered certificates on bicycles from printing houses to dealers. Today, in the age of supercomputers, artificial intelligence, and quantum computing, it still takes two days to clear a trade. Ever wonder why?
When shareholders sell a stock from a cash account, the cash is not available for them to re-deploy for two more days. For most investors, this is an untenable situation. But lucky for them, they can open a margin account which gives them instant access to their cash, courtesy of the house.
But the arrangement is not so courteous. Once an account is marginable, brokers are allowed to lend shares to short sellers. And lend they do, at rates that can reach levels of 20-40% on an annual basis.
Why would anyone pay that much to borrow shares? The academics, after all, tell us shorting is not a good risk-vs-reward proposition. The upside is limited while the downside is unlimited. Obviously, however, shorts would not pay that much unless the payoff was bigger. And it is. Why? Because the game is fixed.
Short selling is perhaps the only example in the financial system when giving something away for as low a price as possible is incentivized. Short sellers will sell the majority of the shares they borrow right off the bat, often on the gray market, for as high a price as possible. But then they set aside a minority of shares to sell at as low a price as possible going forward to weaken the conviction of other holders and induce them to sell.
Offering shares in drips and drabs for virtually nothing would have little effect on the stock price of a mature company with a large market capitalization and efficient price discovery, but it is a different story for small caps. The Wolf on Wall Street says one of the preconditions for manipulating a share price is the ability to corner a stock. Short sellers concentrate on companies with smaller market capitalizations and poor liquidity.
Long-term shareholders of illiquid small caps are the victims. When liquidity is low, sales in drips and drabs at extremely low prices can turn into a flood. The published share price is nothing more than the last price at which the stock trades. A garage sale of a single share by a short seller when there are few buyers can drive the tape price down rapidly and substantially. This weakens the conviction of the long-term holders who, after all, are only human. Enough Chinese water torture undermines the strongest of convictions for even the most promising of companies, eventually causing the big shareholders to sell out, driving the stock price lower still. Is this really what we want?
Once a stock price has fallen significantly, 20-40% or more, suddenly short sellers will reverse course, buy shares back to return to lenders, and then go long (i.e., buy) shares in excess of the number they need to return to share lenders. That way, short sellers not only profit from the short when the stock bottoms, they participate in the capital gain from the “squeeze” on the way back up. They play both sides of the trade. They have their cake and eat it too. It is the closest thing in our financial system to free money with the exception of high-speed trading.
The conflict of interest at brokerages lending out shares to the shorts is as extreme at it is unregulated. The SEC engages in tough policing of conflicts of interest at fiduciaries like financial advisors, where failure of an advisor to divulge a conflict of interest results in civil and criminal penalties. But policing flagrant conflicts of interest amongst custodial brokers lending out shares belonging to long clients to those who go short occurs every day, and there is simple reason for this: there is no law against it.
Free-market advocates claim that short-sellers are good for the system because they provide liquidity in markets. That is like saying bleeding a patient of three pints of blood is good because it lowers the blood pressure. Indeed, short sellers cause more trading around illiquid targets. But panic selling and short-squeeze buying is not the kind of trading anyone other than the shorts benefit from. Why have capital gains laws encouraging long-term holding of shares yet short-selling laws that incentivize exactly the opposite? The small companies targeted by the shorts would likely have better liquidity in the long-term without the shorts scaring away long-term holders, deflating the stock price and trading volumes.
The destabilizing effects of short-selling are exacerbated by an SEC that has long been asleep at the wheel enforcing laws prohibiting naked short-selling. The clearing banks could have gone under if the Gamestop squeeze had not been halted by a trading freeze because there were not enough shares to cover the short exposure at the DTCC. The potential upside to Gamestop shares, and therefore loss to the clearing house, was infinite in part because short sellers were allowed to manipulate the price so low in the first place, in part because shorted shares (70 million) exceeded float (50 million).
Short-selling as practiced today is at best a distortion of the free market that underpins our economy, an aberration that eats at the system like a tapeworm. At worst, it can bring down the system by bankrupting the clearing houses. The Gamestop incident was a perfect storm in a comedy of errors. Simple changes can be made to prevent a recurrence: 1) The uptick rule, allowing short selling only when the last trade of a stock is green, should be made a permanent feature of the investment landscape. 2) Trades should be settled immediately not in two days. 3) Shareholders whose shares are custodied at brokerages should approve when their shares are loaned out and be compensated for it. 4) Existing laws against naked short selling should be enforced vigorously. This is not rocket science.