Follow Us GraphicFacebook IconTwitter IconLinkedIn Icon
Search Graphic

Expert Financial Analysis and Reporting

Part 7: Illegal Naked Shorting: DTCC Continuous Net Settlement and Stock Borrowing Programs Have Loopholes That Facilitate Illegal Naked Shorting

Acronyms Used Frequently in This Report

DTCC: The Depository Trust & Clearing Corporation (DTCC) provides clearing and settlement services to the US financial markets that handle the exchange of nearly all securities and cash on behalf of buyers and sellers. It is also a central securities depository providing central custody of almost all US securities.

DTC: The Depository Trust Corporation is a subsidiary of the DTCC. It is the depository for almost all US securities and keeps records of transfers through electronic record-keeping of securities balances.

NSCC: The National Securities Clearing Corporation (NSCC) is a DTCC subsidiary that provides clearing and settlement for almost all securities transactions in the US two days after a transaction (T+2). It also guarantees completion of certain broker-to-broker securities transactions.

There is an integral relationship between the DTCC and hedge funds. The DTCC is owned by Prime Brokers; these are Goldman Sachs, Morgan Stanley, Merrell Lynch and other household name investment banks. Prime Brokers provide basic services to hedge funds that allow them to trade with multiple brokerage houses while maintaining a centralized master account at their prime broker containing cash and securities. The prime broker offers stock loan services, portfolio reporting, consolidated cash management and other services. Hedge fund support is a very meaningful percentage of the net income of Prime Brokers.

DTCC Performs a Critical Function but also Facilitates Illegal Naked Shorting

My previous blogs on illegal naked shorting were intended to build a base of knowledge necessary to begin to understand how this tactic has become a broadly accepted, routine business practice on Wall Street used to manipulate stock prices. Essential to this illegal enterprise are loopholes in the clearing and settlement businesses of two key subsidiaries of the Depository Trust and Clearing Corporation (DTCC)-the Depository Trust Company (DTC) and the National Securities Clearing Corporation (NSCC). These subsidiaries use Continuous Net Settlement (CNS) and the Stock Borrowing Program to facilitate efficient liquid markets in securities. While essential to smoothly functioning markets, these two programs have loopholes which facilitate illegal naked shorting.

The DTCC has evolved as a solution to the crisis of the 1960s when the clearing and settlement of securities was done through the physical exchange of securities for cash. An explosion in trading overwhelmed the system resulting in a crisis for the markets. In response, legislation was passed in which over time, the DTCC evolved as a paperless, electronic clearing and settlement system that now routinely handles billions of shares changing hands each day. It allows buyers and sellers to promptly receive securities that they purchase or cash due them for selling securities. It performs marvelously well to keep our equity market smoothly functioning and is essential to our economic system, but it can also facilitate illegal naked shorting.

The objective of this report is to show how market makers can exploit loopholes in DTCC and Regulation SHO to create counterfeit shares that can be used in illegal naked shorting. Hedge funds can be complicit in this, but from a legal standpoint have plausible deniability because they don’t actually execute the trades. Overwhelming empirical evidence has led me to believe that the amount of counterfeit shares that have been created and are circulating in the market is staggering. However, the data needed to substantiate this charge is hidden deep 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 virtually no transparency to outsiders and regulatory oversight is ineffective and indifferent.

The process through which counterfeit shares are created is complex and more than a little confusing.  I have tried to simplify it as much as possible, but if you are like me you will likely have to read and reread some sections. I urge perseverance. It is well worth your time if you want to come to grips with illegal naked shorting. I also need to issue the caveat that understanding all of the intricacies of illegal naked shorting would require a very large team of lawyers skilled in securities law and people skilled in clearing and settlements procedures. This is far too big a job for one person to cover thoroughly and as a layman I may have made some technical or other mistakes in this report. Still, I think that it conveys to the reader this malignancy of illegal naked shorting that is a cancer in our securities markets.

Physical Transfer of Stock Certificates Has Been Replaced by Electronic Data Entries

The success of the DTCC in maintaining stable, efficient equity markets is importantly based on two innovations. The first is the replacement of the physical movement of stock certificates with a book entry accounting system, which electronically records and transfers ownership of securities. Investors do not own stock certificates issued by Companies. Instead, these certificates are actually stored in a central vault in the DTC. When an investor buys a security through a broker, the investor’s name does not appear on the stock certificate. The names that do appear are those of broker dealers who have an account with the DTC; this is referred to as being held in “street name”.

The broker dealer holds the stock in a book-entry form. The actual custody, physical control and even the official ownership of stocks (and other securities) is done through Cede and Company, which processes the transfer of stock certificates on behalf of DTC. CEDE was founded in 1996 as a private partnership of employees of DTCC and is a separate legal entity from the DTCC. Cede is structured as a partnership so that each general partner can order transfers of stock registered in the name of the partnership. This eliminates the requirement for a separate corporate resolution to the stock issuer's transfer agent or stock registrar to validate the authority of each transfer. Cede technically owns substantially all of the publicly issued stocks in the United States. Thus, investors do not themselves hold direct property rights in a stock, but rather have contractual rights with Cede.

The immobilizing and dematerializing of all securities of companies allows for purely electronic exchanges in which book entries in the accounts of DTC participants account for changes in ownership. The good thing about this is that it allows rapid settlements with little risk. However, it is also totally non-transparent to outsiders, including the SEC. Only the management of DTCC and the prime brokers who own DTCC actually know what is going on. It is eyebrow raising that the DTCC is a private company, owned by its members which are household name investment banks such as Goldman Sachs, Morgan Stanley etc. It is also staggering to think that the SEC has waived control of clearing, settlements and securities custody in US equity markets to DTCC.

Continuous Net Settlement System Used by the NSCC

In the clearing and settlement systems of the 1960s, the New York Stock Exchange, NASDAQ, and the American Stock Exchange as well as smaller exchanges each had their own clearing corporations that settled trades in their respective markets through physical exchanges of securities and cash. A second major innovation of the new system is that with its NSCC subsidiary, the DTCC created a single, central clearing and settlement process that handles virtually every securities trade in the United States and which is all done through electronic data transfer. It processes almost all broker-to-broker transactions involving equities as well as corporate and municipal bonds, American depositary receipts, exchange-traded funds, and unit investment trusts.

Before the advent of electronic technology and central custody at DTC, shares could be held as registered shares in which the company maintained a register of owners of shares and changes of ownership. A stock exchange could also be done with bearer shares in which ownership was transferred simply by handing the bearer share certificate to the new owner. To understand the innovative approach of the NSCC, let’s consider what was done in the old days of the 1960s with a simple example. Investor A would buy a stock for his account that was sold to him and came directly from the account of investor B. Investor A would now own the stock certificate previously owned by Investor B and in exchange investor B would receive cash from Investor A. This is familiar to us because it is how we buy most things, but given the sheer magnitude and rapidity of daily transactions this would now be impossible for securities trading. The solution of the NSCC was an agreement on the part of all participants to no longer handle each trade individually, but to use a new system called Continuous Net Settlement (CNS) based on an automated book-entry accounting system that centralizes the settlement of transactions.

In the CNS system, Prime Brokers have an account with the DTC as does each of their customers (other brokers, market makers, hedge funds, individual investors All interactions between these accounts is done electronically. The information is updated in real time making it possible to immediately ascertain the current status of different investments and money balances in the prime broker and customer accounts. The clearance and settlement system of the NSCC functions through a system called multilateral netting. Here is how it works in a highly, highly simplified scenario.

  1. In executing a customer order, Broker A buys 1000 shares of XYZ stock from Broker B.
  2. Later in the day, Broker A sells 1000 shares of XYZ to Broker B.

Under the old physical system of the 1960s, in the first trade Broker B would deliver 1000 shares of XYZ to Broker A in exchange for cash. Then for the second trade later in the day, Broker A would deliver 1000 shares of XYZ and receive cash from Broker B. With the new NSCC approach, these two trades would be netted out so that there would be no movement of the electronic certification connoting ownership between the two brokers DTC accounts. In the real world of complex trading, there likely would be many, many buy and sell transactions involving XYZ between broker A and B during the day. Moreover, Brokers A and B would also interact with multiple brokers C, D, E etc. in buying and selling XYZ. The NSCC approach in this complex trading environment, is to net trades of all prime brokers through Continuous Net Settlement.

NSCC settlement is two days after the trade (T+2) at which time all transactions for each NSCC member is netted for XYZ. They are further netted against any previous trades in which there were failed to deliver securities. If the Prime Broker has sold more shares than it has bought (net short), it owes shares to the NSCC. The inventory of XYZ in the broker’s account at the DTC is checked to see if there are available shares that can be transferred to cover the short obligation. In the case of net long positions, they are automatically credited to the member's DTC account. Also, daily money settlements are debited or credited to the member's account.

This may be a bit mind spinning so let me give you another simple example of how this works. Throughout the day Broker A might handle multiple transactions in XYZ for its customers as follows:

  1. Sells 500 shares to Broker B
  2. Buys 1000 shares from Broker C
  3. Sells 2000 shares to Broker D
  4. Has 500 shares of XYZ on deposit at its DTC account

Broker A at settlement (T+2) is net short 1000 shares of XYZ (-500+1000-2000+500) and turns to the Stock Borrowing Program.

NSCC’s Stock Borrow Program

When a broker is net short a stock, it has two days to locate and deliver a borrowed share to the purchaser and the purchaser has two days to deliver the money. However, there could be a situation as in the above case in which a broker is net short of XYZ on settlement day and does not have enough shares of XYZ in inventory at the DTC to cover the net short position. In this case, the broker has sold more shares that it has available as in the previous example in which Broker A is net short 1000 shares at settlement. Prior to the advent of the electronic transfer, if the buyer did not receive his shares by settlement day, they kept their money and undid the transaction. This is not the case under CNS because the NSCC guarantees the trade so that even if the seller of the stock fails to deliver, the transaction goes through. I will explain later how this can be used to create counterfeit shares.

Each member’s position at settlement (T+2), whether it is net short or net long, is known to the DTC. Let’s think of this in terms of stock XYZ. If the member is net short, the DTC compares the number of net short positions to shares of XYZ in the member’s DTC account to determine if the account at the DTC holds enough shares in it to settle the position. If there are enough XYZ shares in tis DTC account to offset the net short, these shares of XYZ are then sent to the DTC account of members who loaned the shares.

If the member does not have enough shares in its DTC account to cover its obligation, the NSCC will borrow shares through the Stock Borrow Program. This program allows members with net long positions to lend out shares to members who are net short. A Prime Broker who has a net long position in XYZ can put them into the Stock Borrow program. This surplus can then be loaned to another Prime Broker who has a net short position to cover its deficit. Each day, members inform the NSCC as to how many shares they are willing to lend. The NSCC then determines how many shares it needs to borrow from members who are net long XYZ to cover the outstanding shares of members who are net short. Once the DTC establishes the number of shares it needs to borrow to cure the net shorts (failures to deliver) at settlement, it uses a formula to determine how the necessary shares will be borrowed from members who are net long.

When the NSCC borrows shares from a lending member, it credits that member’s account with cash equivalent to the full market value of the securities borrowed.  The lending member earns interest on that amount while the stock loan remains outstanding.

Creating Counterfeit Shares through the Stock Borrow Program

There is a loophole in the stock borrowing program that allows for the creation of counterfeit shares. For the sake of example, let’s assume that the parties in a hypothetical example are Hedge Fund A, Broker A, Investor B, Broker B, a market maker and the DTC and NSCC. Let’s look at a highly simplified example in which Hedge Fund A asks broker A to short 2,000 shares of XYZ at $10.00 per share.

  1. Broker A transmits Hedge Fund A’s short sell order to a Market Maker in XYZ stock (this could be either the broker itself or another market maker.)
  2. The Market Maker confirms immediately to Broker A that the trade is complete without first locating the shares; he is naked short the stock. Under Regulation SHO this is legal.
  3. Investor B through Broker B buys the 2,000 shares offered by the Market Maker at $10.00 even though the market maker has not located 2,000 shares to borrow.
  4. If at T+2, the Market Maker still hasn’t found a locate, he is in a fail to deliver situation. In the system of the 1960s, the trade would have been broken and $20,000 would be returned to Investor B’s account, but because the NSCC guarantees all transactions, the stock borrowing program comes into play and the settlement proceeds with the NSCC borrowing stock from other member firms.
  5. The DTC identifies Broker C having a net long position of 2,000 shares which it is willing to lend to NSCC.
  6. At settlement (T+2), Hedge Fund A’s account at the DTC is credited with cash of $20,000 (2,000 shares at $10.00). Investor B’s account at the DTC is now credited with owning 2,000 shares of XYZ at $10.00 even though the market maker failed to borrow the shares. Broker C is credited to receive interest on $20,000, the value of the stock it has loaned.
  7. Broker C loaned 2,000 shares of XYZ, which it took from its customer accounts, to the NSCC. However, the NSCC accounting credits customers of Broker C with still owning 2,000 shares of XYZ.
  8. This is the critical point at which counterfeit shares have been created. The NSCC shows customers of Broker C as still owning the 2,000 shares of XYZ. However, Investor B is credited as owning the same 2,000 shares. Presto, there are 2,000 new counterfeit shares outstanding that were never issued by the Company.
  9. Under Reg SHO, the Market maker has until T+6 to locate stock and close out the 2,000 shares of XYZ it has borrowed through the stock borrow program from Broker C. Under Regulation SHO, if a locate has still not been found at T+6, the Market Maker must purchase 2,000 shares in the open market and return them to Broker C. However, Wall Street has a bag of tricks to get around this requirement. One of which is simply to ignore it. Another is to roll the position to another broker-dealer. Oftentimes, fails to deliver can last for months or years. The SEC seems strangely unwilling or unable to enforce this provision of Regulation SHO.

If the Fail to Deliver is not corrected, there is another perplexing rub to this situation. Going forward, the NSCC system does not differentiate between counterfeit shares and real shares. Both the 2,000 legitimate shares that were originally in the customer accounts at Broker C and the 2,000 new unauthorized (counterfeit) shares given to Investor B can both be loaned to cover other net short, fail to deliver positions. This process can be repeated ad infinitum to flood the market with counterfeit shares. Also, the counterfeit shares can be voted in proxy issues pertaining to Company XYZ. I will explain how in a later blog.

Here are some of the inexplicable things about this process, which benefit Wall Street and penalize investors.

  1. The 2,000 shares loaned by Broker C to make good on the Market Maker’s delivery obligation actually do not belong to Broker C.
  2. They belong to customers who have margin accounts at Broker C.
  3. The customers of Broker C in almost all cases don’t know that their shares have been loaned out by Broker C.
  4. Broker C receives interest on the cash value of the stock being lent even though they do not own the shares. The customers of Broker C who do own the stock receive no economic value.
  5. The economic interest of customers of Broker C is to see the price of the stock rise. The loaning of their stock to short sellers who want the stock to go down is against their economic interest.
  6. Brokers are supposed to put the economic interest of their customers before their own. Clearly, this is not the case with the Stock Borrowing Program.

Tagged as + Categorized as LinkedIn, Smith On Stocks Blog


  1. TDPeterson123 says:

    Who is supposed to have oversight of these various organizations, the SEC? The picture you’ve been painting so clearly explains and exposes the corruption by the key players in this system. The lack of oversight isn’t an accident, nor are the lack of consequences to the abusers of the system. .

  2. The SEAC has oversight responsibilities but leaves much of the governance issues to the DTCC and Prime Brokers.


You must be logged in, or you must subscribe to post a comment.