Expert Financial Analysis and Reporting

Introduction

I worked on Wall Street as an analyst for nearly 40 years and was involved in the stock market on a day to day basis. Throughout this time, I was focused on fundamental developments that would give an insight into the potential for a company to grow its sales and profits and then trying to translate that into future stock performance. Like many investors, I believed that this was the overarching factor in predicting future stock performance. I had no inkling and I would have been shocked if someone had told me ten years ago what the experience of the past decade has taught, i.e., in many, many cases (particularly for small companies) fundamentals are not the most important factor determining the stock price.

I left Wall Street some time ago and after a while started my blog SmithOnStocks, with a strategy of focusing on small, under covered biopharma companies. I proceeded to make recommendations based on the belief that if a company achieved an important milestone as in a clinical trial or regulatory development that the stock price would go up, but this seemingly irrefutable approach just wasn’t working. I saw in case after case that stocks were going down on unquestionably good news and were being obliterated on disappointing news. It just wasn’t one or two stocks. It was the case with many small stocks that I was following both closely and from afar. An exciting new development would paradoxically lead to a stock price decline. I have come to believe that this is the result of a routine business practice on Wall Street perpetrated by hedge funds and aided and abetted by household name financial institutions who enable illegal naked shorting.

I have begun to write a series of blogs that explain my analysis of this stock manipulation scheme which is complex and embedded in Wall Street business practices. The initial blogs are laying the groundwork for later and more complex discussions of illegal naked shorting and how it is used to manipulate stocks (down). I have had to learn a lot as I go and a key part of this learning process was for me to become more familiar with how Wall Street interacts with hedge funds to facilitate this scheme. In upcoming reports I will refer to a number of Wall Street businesses that are involved. So who are they? They are hedge funds, brokers, prime brokers, broker dealers, market makers and the Depository Trust & Clearing Corporation (DTCC). This report gives a rudimentary overview of each of these entities that is intended to help put future blogs in perspective

Hedge Funds

Hedge fund is an amorphous term that can refer to a vast number of pooled investments with widely varying investment styles and objectives. The hedge fund manager raises money from sophisticated, outside investors and then invests it according to a particular strategy. As examples, there are hedge funds that: specialize in

• long-only equities, meaning they only buy common stock and never sell short,
• short only equities who only short stocks,
• private equity groups that buy entire companies, take them private, revamp operations and then bring the companies public again,
• junk bonds,
• real estate,
• specific sectors of the stock market like biotechnology,
• ad infimum.

In short, they can and do invest in just about anything. The original hedge funds were structured to hold stocks both long and short (positions were balanced or hedged) to reduce risk with the idea that investors could make money regardless of whether the market rose or fell. The name stuck and expanded to include all sorts of pooled capital arrangements.

Hedge fund managers market themselves as experts who can deliver exceptional returns in comparison to the market. They are paid based on the performance of their portfolios. A common payment is that the hedge fund receives 2% of net assets under management and 20% of profits above a predetermined hurdle rate, say a 15% increase in the portfolio. Hedge fund managers are incented to take enormous risks and are under intense pressure to perform, usually on a short term basis. In order to do this, many use extreme leverage and aggressive and even illegal trading schemes to beat the market. At stake are huge fortunes or miserable failure. Faced with this dire binary outcome, many hedge funds have been attracted to the manipulation of stocks using illegal naked shorting. It is about as close to a sure thing as there is in the stock market.

Hedge funds are only available to accredited, sophisticated institutions and individuals with significant assets. Interestingly, pension funds are huge investors in hedge funds seeking exposure in areas in which they lack internal expertise such as real estate or a particular segment of the market such as biotechnology. Hedge funds are relatively unregulated and unlike mutual funds, they are not subject to some of the regulations that are designed to protect investors. Depending on the amount of assets being managed, some hedge fund managers may not be required to register or to file public reports with the SEC.

Brokers

Brokers are intermediaries who have the legal authorization and expertise to buy or sell securities on an investor's behalf and maintain an account record that shows investors their investment holdings and transaction history. They may also provide value added services such as research, retirement planning or providing loans to increase leverage. Brokers are regulated and licensed and have an obligation to act in the best interests of their clients. Goldman Sachs, Merrell Lynch, Morgan Stanley, JP Morgan, UBS et al have a brokerage division.

Dealers

In contrast, a dealer is a principal that facilitates trades on behalf of itself. On Wall Street, many of the large firms such as Goldman Sachs, Merrell Lynch, Morgan Stanley, JP Morgan, UBS et al are both dealers and brokers and are referred to as broker-dealers. Within these firms, there are giant hedge funds operating in every corner of the securities markets which may trade against the interest of brokerage customers. There is a clear conflict of interest that is particularly apparent in short selling and illegal naked shorting.

Conflict of interest is pervasive on Wall Street. In fact, as you pull off the layers of the onion on business models of Goldman Sachs, Merrell Lynch, Morgan Stanley, JP Morgan, UBS et al, they operate in the many aspects of Wall Street’s businesses, there is just one conflict of interest after another. There is no question that Wall Street has been a major driving force in building the economy and incredible standard of living that we in the US have achieved. Unfortunately, Wall Street firms often in conjunction with hedge funds have incredible power to abuse the system.

Market Makers

The role of a market maker is to create a market for investors to buy or sell securities. They are obligated to make markets in specific securities by posting at the same time a bid (to buy stocks at a specific price) and an offer (to sell stocks at a specific price). Market makers are wholesalers who trade for their own account and try to make money from the spread or difference between the bid and offer; these are known as principal trades. Market makers are constantly entering and adjusting quotes to clear buy and sell orders. They provide the essential role of providing liquidity for the market.

The key difference between a broker and a market maker is that brokers execute a trade on behalf of others to whom they have a fiduciary obligation, while dealers execute trades on their own behalf. Maintaining markets requires that market makers put significant amounts of capital at risk. Once again this is a situation in which firms like Goldman Sachs, Merrell Lynch, Morgan Stanley, JP Morgan, UBS et al, provide a critical role in providing liquidity to the market and yet the potential for conflict of interest is also very high. This is a pattern that seems to pervade most operations of these firms.

Broker- Dealer Versus Market Maker

A broker-dealer is in the business of buying and selling securities as an agent for clients or as a principal for its own account. If the broker-dealer is a market maker in a particular stock, they may be required to purchase stock that the client is selling. They may then sell this stock to another buyer and make a small profit keep the shares in a proprietary portfolio.

All market makers are broker/dealers, but not all broker-dealers are market makers. Market making is a specific activity of providing liquidity in one or more securities, usually equity securities, by standing ready to both buy and sell that security, and quoting prices and often keeping an order book for that security if there is sufficient depth of market.

Prime Broker

Prime brokers provide specialized, complex financial services to financial institutions lacking internal infrastructure. These include securities lending, providing funds to increase leverage (risk arbitrageurs, e.g.) and cash management. They cater to hot money traders like hedge funds, but also deal with pension funds and other financial institutions. For most hedge funds, prime brokers are essential to success.

Prime brokers are operating divisions of large investment banks such as Goldman Sachs, Merrell Lynch, Morgan Stanley, JP Morgan, UBS et al. For example, as of 2018, Morgan Stanley stated that it had 800 clients, mostly hedge funds. There is a troubling symbiosis between prime brokers and hedge funds. Serving hedge funds through prime broker services may account for perhaps 20% of more of profits for the investment banks and their services are critically important to hedge funds. Prime brokers and hedge funds view each other as partners to the detriment of other investors in the market. This is abundantly clear in the case of both legal and illegal naked shorting. And of note, these firms also operate their own hedge funds.

Depository Trust and Clearing Corporation (DTCC)

I wrote an introduction about the DTCC in a my previous blog (part 3 in illegal naked shorting series) that you may want to refer to. In that article, I discussed how the DTCC is responsible for the exchange and transfer of securities on behalf of nearly all buyers and sellers of stocks in the US. It also functions as a securities depository by providing central custody of securities in which all paper stock certificates are immobilized in a central vault which allows stock ownership to be transferred with digital entries. The DTCC is owned by prime brokers. It functions on an at cost basis so that all revenues in excess of cost are remitted to the prime broker owners

The DTCC/ prime broker infrastructure seems to handle the staggering complexity of clearing almost all stock and other securities trading in the US 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.

In future articles, I will go into some detail on how the business model of the DTCC can facilitate short selling, legal naked shorting and illegal naked shorting. Not all naked shorting is illegal and indeed plays a role in providing liquidity to the markets. However, the practice of naked shorting is often abused with the result that huge quantities of counterfeit shares never issued by a company, can be created and sold short. This is at the heart of one of the biggest criminal enterprises in the US. How this is done is complex so bear with me as I try to understand and explain this in future blogs.