Expert Financial Analysis and Reporting

Clearing and Settling of Stock Trades

Most of us when we enter a buy or sell order for a stock give almost no thought to how key aspects of the trade are carried out. We have great confidence that the trade will be handled in accordance with our instructions and accurately reflected in our brokerage account. To do so, there are three components involved in each stock transaction.

• Clearing is the process of updating the accounts of the parties involved on the two sides of the trade to arrange for the transfer of securities and money. This is done through Prime Brokers and the Depository Trust & Clearing Corporation (DTCC), which is a company privately owned by Prime Brokers. A Prime Broker (aka broker dealer) can sometimes clear their own transactions by moving shares from one of their customer accounts. If the transaction cannot be completed within the account base of the Prime Broker, they turn to another Prime Broker and clear through the DTCC. Only member Prime Brokers may directly use these clearing services of the DTCC. Investors and non-member brokerages gain access through having accounts with member firms. It is the responsibility of Prime Brokers to ensure that the securities are available for transfer and that the counter party has adequate funds to pay for the transaction.
• Settlement follows clearing and is the simultaneous process in which securities are delivered in exchange for payment, usually money.
• Central Certificate Depository There is a centralized depository for securities operated by DTCC which holds the paper stock certificates and allows ownership to be electronically transferred through a book entry rather than the physical transfer of stock certificates. This allows brokers and financial companies to hold their securities at one location where they are immediately available for clearing and settlement. This is where your brokerage account is lodged.

For one trade, execution of these three components is no big deal, but think about the staggering number of trades that are made each day. Stock trading in the US results in the clearing and settling at the end of each day of somewhere around 6 billion shares which are involved in perhaps 1 million trades (obviously day to day trading activity can vary significantly). This trading is done in something around 1.5 million securities issued by companies that have a combined value of over $30 trillion. The current US system is all automated and has to be able to cope with the volume spikes and market volatility that we are all too familiar with.

Historical Perspective

To understand and appreciate the current, electronic, paperless system, it is useful to look at some history to understand how clearing, settlement and certificate depositing were handled in the pre-electronic era. Until the mid to late 1960s clearing and settlement were done by hand and security certificates and checks to pay for securities were shuffled between broker dealers by messengers. An explosion of trading strained this system to the breaking point and the short term solution was to trade on Monday and Tuesday, settle on Wednesday and then trade again on Thursday and Friday and settle on Saturday. This trading explosion occurred as the main IBM frame computers were being introduced which were capable of handling massive amounts of data and computers became central to solving this crisis.

The Crucial Role of the Depository Trust & Clearing Corporation (DTCC)

I am not going to attempt to show in any detail how the clearing, settlement and depositing of securities system evolved from the crisis of the mid-60s to what is now a totally paperless, electronic system. But briefly, Congress passed legislation in 1971 for two new service organizations, whose objectives were the speeding up the clearance and settlement process. The Depository Trust Company (DTC) was established as the nation's principal securities depository, with the mission to convert paper certificates to electronic book entries and to immobilize the paper certificates and keep them in a vault at the DTC. (No more shuttling by messengers.) The National Securities Clearing Corporation (NSCC) was established at the same time to speed up clearance and settlement services.

In 1999, the DTC and NSCC were combined as part of the critical infrastructure of the Depository Trust & Clearing Corporation (DTCC). Today, the DTCC performs the exchange and transfer of securities on behalf of nearly all buyers and sellers of stocks in the US and also functions as a central securities depository by providing central custody of securities. This is where your brokerage account is actually lodged. The DTCC is a private company owned by Prime Brokers, who form a second critical element of clearing and settling stock trades. They include household name Prime Brokers such as Merrill Lynch. Goldman, Sachs, Morgan Stanley, JP Morgan, UBS and others.

The current system has proven to work effectively through volatile periods and copes with the enormous amount of dally volume stemming from computer based, high frequency trading (HFT). Computers can literally execute thousands or more trades in a second and I have seen estimates that the average HFT position is held for 14 seconds. HFT is estimated to account for 75% of daily volume. I for one can’t understand the economic or societal benefit of this, but that is a discussion for another day.

The Prime Broker/ DTCC infrastructure seems to handle this staggering complexity with ease. Without it our capital markets could not function and our economy would collapse. However, there is a dark side to this in that there is virtually no transparency that allows outsiders to determine what is going on inside the DTCC. As a private company, the DTCC avoids much regulatory oversight and regulatory reporting of what it is doing and is almost totally opaque to outsiders. The Prime Broker/ DTCC monopoly executes almost all stock trades in the US and keeps the records of these transactions. This is disturbing and even sinister because it allows for the manipulation of trading and data to the benefit of the Prime Broker owners and to the detriment of everyone else. There is no transparency to outsiders and regulatory oversight is ineffective and indifferent.

Allegations that the DTCC and Prime Brokers Misuse Naked Shorting

It has been alleged in tens or hundreds of lawsuits that the DTCC and its Prime Broker owners have abused their monopoly position to create numerous techniques that allow for the creation of counterfeit shares through naked shorting that facilitate stock manipulation by hedge funds. Law suits have been brought against Merrell. Lynch, Goldman Sachs, Morgan Stanley, JP Morgan, UBS, other market makers and also the DTCC. The Prime Brokers and DTCC have fought back ferociously against these lawsuits with great success and have been largely successful in blocking attempts to gain access to their transaction data bases. The information that they do release is incomplete, self-serving and misleading.

Bear in mind that in the case of illegal naked shorting, hedge funds have plausible deniability of wrong doing. They can simply claim that they are entering a short sale order and are not aware as to whether the order was executed with legal shorting or illegal naked shorting. It is the Prime Brokers who are culpable. While this is a pretty solid legal argument, it is hard to imagine that these hedge funds are not totally aware that Prime Brokers will create counterfeit shares through illegal naked shorting to facilitate their stock manipulation schemes. There is reason to suspect collusion.

To date, there have been a considerable number of actions alleging that Prime Brokers have been involved in illegal naked shorting that has resulted in stock manipulation. The vast majority have been dismissed but there have been some successful civil actions brought that have resulted in modest awards to plaintiffs. In one case, Overstock.com was awarded $20 million in a civil suit that accused Merrill Lynch of creating counterfeit shares through naked shorting. Goldman Sachs was also named in the suit. Action against them was dismissed on jurisdictional grounds, but the judge stated that Goldman, like Merrell, had been creating counterfeit shares also. See “Overstock.com Accepts $20 Million to Settle Market Manipulation Case”. In a separate action, the SEC fined Goldman $15 million for illegal naked shorting. See "SEC Charges Goldman Sachs With Improper Securities Lending Practices".   It is estimated that these firms bring in billions of dollars each year from legal and illegal naked shorting activities. The fines leveled in the above cases are just a small cost of doing business.

There have also been criminal cases brought against Merrell, Goldman Sachs, Morgan Stanley, and UBS alleging Racketeer Influence and Corrupt Organization (RICO) violations, securities fraud and other charges. I am not aware of any plaintiffs being successful in a criminal proceeding but there are some in the process of being tried. I wonder if the CEOs of these firms are aware of these lawsuits.

Why Do Lawsuits Against the Prime Broker/ DTCC Fail So Often?

The common thread of failure in the lawsuits against the Prime Broker/. DTCC monopoly has been the lack of physical evidence showing trading abuses. The monopoly ferociously fights to keep its data out of the public domain. They have been largely successful in blocking outside access to the data that is locked up in DTCC’s closely guarded data bases that is necessary to show criminal culpability. Plaintiffs may offer compelling empirical evidence of stock manipulation but it is almost always dismissed for lack of evidentiary evidence of actual damage caused by illegal naked shorting. Plaintiffs have to show evidentiary evidence to prevail, but the DTCC won’t provide access to its data bases that would provide such evidentiary evidence. This is just one of several instances in which federal law is heavily weighted in favor of the Prime Broker/ DTCC monopoly.

Let’s step back for a moment and think about this. I think that I am unquestionably correct in saying that the electronic clearing and settlement system that is managed by the Prime Brokers and the DTCC monopoly is critical beyond measure to functioning of capital markets which are the cornerstone of our economic system. However, this monopoly position can also enable an activity like illegal naked shorting. One would think that regulators and legislators would make it their highest priority to make sure that the DTCC is totally transparent and its data is readily accessible to the public. However, in point of fact the DTCC is quite opaque and the limited data it does release is incomplete and often misleading. It is known for its ferocity in fighting off or ignoring subpoenas. Remember that its owners-Merrell, Goldman Sachs, Morgan Stanley, JP Morgan, UBS, et al -are enormously powerful financial institutions with great influence over legislation and regulation affecting them

Does ShareIntel Have an Answer?

The core technology base of ShareIntel has allowed them to take the fragmentary data and information released by the Prime Brokers and DTCC to identify markers of naked shorting that allows the creation of counterfeit shares used in stock manipulation schemes. In coming reports, I will try to explain what ShareIntel is doing. I must say that I have had almost no experience in understanding the complexities of this issue and trying to get to just a rudimentary knowledge of the issues has been pains takingly slow, but I am trying. I think that it is important for all investors to understand that there is massive manipulation of stocks (especially those of small companies) and investing decisions must take this into account. I also think that all of us should try to do our part, however small, in confronting this manipulation scheme and to bring it to a halt.