The Real DTCC Discussion

[BigBake1]

SHORT VOLUME

Oh I have a pretty good understanding of “short volume” and I am glad you clarified it from Shorting as that is a position as opposed to a momentary “marked” execution that short volume is. This is not going to be a short answer so you will have to endure the explanation. To start with, a little history here, before 2008 there was no disclosure to as how each trade was initially executed and in fact there was no reliable data as to what was exact to number of naked short sales within the market, in particular abusive naked short sales were the concern.

The SEC did not see abusive naked short sales as a massive problem in fact the direct quote was they are not an issue within our markets. Turns out that was false, there were an alarming number of shares sold without delivery and in some cases there were securities severely impacted by large numbers of abusive naked short sales. So as we know the regulators imposed new Rules and came up with new reports to reign in the process and provide transparency to the entire trade transaction. In particular two points in time are what are concentrated on, the initial execution of a trade and then of course the final settlement of the trade.

Now that we have that out of the way, we can move on to the OTC, the OTC is a Market, not an exchange as many try to claim. The OTC is a quotation service and it requires MMs to quote securities to provide a centralized place for Bids and Offers. Without MMs you have a grey market and well there is no order flow and no liquidity in that market. So each broker has an MM contracted to work for them to aid in execution of trades here in the OTC. As long a security has either a Form 15 and or is an exempted unsolicited quote security the MMs can quote for customers their offers. That is all MMs do here quote customer orders and that is all.

The entire OTC market is electronic from initial trade execution to settlement and requires no human intervention in doing so. Only two reasons humans get involved, you phoning an order in and specializing that order or the other reason a trading error occurs, which requires manual reconciliation. The clearing and settlement process requires no human intervention either as long as a security is in CNS, thus why DTC eligibility is important as the booking is completely hands free. We will deal with quoted and CNS eligible securities in this response.

So back to the regulators and the created reports, the SEC has rules in the 200 series that cover short sales, in particular 200, 201, 202T and 203. The main two here for us are 200 and 203, 200 in particular defines short sales and defines ownership.

Since the new marking requirements apply to all equity securities, not just exchange-listed securities, we are removing them from current Rule 10a-1. The new order-marking requirements differentiate between "long," "short," and "short exempt" orders for all exchange-listed and over-the-counter equity securities.

So here they added OTC securities into the marking requirements, marking a trade “short” is simply defining ownership of the security, in the case of MMs working the OTC none of them own the shares when making a market here.

Under the former marking requirements in Rule 10a-1(d), a broker-dealer could only mark an order to sell a security "long" if the security was carried in the account for which the sale is to be effected, or the broker-dealer is informed that the seller owns the security to be sold, and will deliver the security to the account for which the sale is effected as soon as possible without undue inconvenience or expense.35 We had proposed changing the marking requirement so that a sale could only be marked "long" if the seller owns the security being sold and either the security to be delivered is in the physical possession or control of the broker-dealer, or will be in the physical possession or control of the broker-dealer prior to settlement of the transaction.

You can find everything concerning SEC Rules 200-203 here:

http://www.sec.gov/rules/final/34-50103.htm

So lets get to the meat of it, I will provide a couple of examples of trades that require being marked short. I will use generic trading symbol XXXX for these examples:

Typical everyday trade, I have 20,000 shares of XXXX for sale on the Ask, you however want to purchase 10,000 of the shares at my price. So you enter your order and it is sent to your broker to execute. First thing is a broker electronically checks to see if there are current sell orders that match your request, if not it is off to the ECN. As I stated earlier each broker has an MM working for them to execute trades, the MM for your broker sees your order and knows I have 20,000 shares for trade. Here is where MMs “create” liquidity and order flow, the ECN matches perfect blocks like trade for trade, size and price are automatic initiated trades. In this case you only want 10,000 shares, so immediately the MM sells your broker 10,000 shares short and marks the trade as “short” although you are long in the trade, this gets reported to the Daily Reg SHO report and also on the consolidated tape.

Now nearly simultaneously on a separate leg of the very same trade transaction the MM is buying the cover from my 20,000 share block, and purchases 10,000 shares from me. This gets reported in the Non Tape Transactions Report and both Non tape and consolidated tape are both sent to FINRA for balancing and reconciliation.

The Daily Reg SHO only reports how the trade was initially executed and it does not reconcile based upon the fact the trade was covered as that will be taken care of in another report. Regulators only want to know exactly how the trade was initially executed and that is it. The trade goes off to the DTC and NSCC for clearing and settlement since it is a CNS security and is cleared and settled. According to SEC reports 98% of all trades are cleared and settled within the same day of trade or T+0. Of course regulators give T+3 for settlement, that is trade day plus 3 days for settlement, once it exceeds that it becomes an FTD (Fails to Deliver).

This report is the end of the entire trade transaction, and once a trade goes T+4 it gets placed on the FTD report. Now many will tell you that if it is on the FTD it means it was either shorted or abusively naked shorted. Both are in fact wrong and the SEC provides clarity as to what the data does not imply:

Please note that fails-to-deliver can occur for a number of reasons on both long and short sales. Therefore, fails-to-deliver are not necessarily the result of short selling, and are not evidence of abusive short selling or “naked” short selling.

http://www.sec.gov/foia/docs/failsdata.htm

So here it is clear as day that the data does not imply anything towards what happened to fail on settlement there are multiple reasons that cause FTDs including error trades and so forth. But there are also trades enacted by financiers in these securities that cause FTDs and even threshold flags to occur, that is covered by SEC Rule 203:

Rule 203(b)(1) for situations where a broker-dealer effects a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200, although, through no fault of the customer or the broker-dealer, it is not reasonably expected that the security will be in the physical possession or control of the broker-dealer by settlement date, and is thus a "short" sale under the marking requirements of Rule 200(g) as adopted.70 Such circumstances could include the situation where a convertible security, option, or warrant has been tendered for conversion or exchange, but the underlying security is not reasonably expected to be received by settlement date.71 Rule 203(b)(2)(ii) as adopted provides that in all situations, delivery should be made on the sale as soon as all restrictions on delivery have been removed, and in any event no later than 35 days after trade date, at which time the broker-dealer that sold on behalf of the person must either borrow securities or close out the open position by purchasing securities of like kind and quantity.

So convertible debts for example create “marked short sales” and FTDs if they are not delivered right away. This is the cause for huge numbers in Daily Reg SHO and also FTDs. You commonly see these massive T-Trades at the end of the day in some securities which are a good sign of dilution but trades executed throughout the day from the debt conversion will all be marked short in accordance with SEC Rule 203. This is to protect the MM due to the possible restriction still being in place during settlement. In fact it is not uncommon for debt holders to sell their shares while still being restricted, they have their letters for conversion to act on.

This commonly creates huge FTDs and trips threshold flags for days leading to speculation that there is a massive short squeeze coming. Sorry to say that no in fact it is 99% of the time due to financiers selling shares before their restricted legend is removed and they have up to 35 days to cover those trades as you can see. During normal market making if there is a trade that becomes an FTD the MM has 13 days to cover the trade and is forced to buy in at that point.

There is another type of trade that causes a “marked” short designation and that is an internalized order. This is caused by someone using a “market order” rather than a limit order. When such an order is placed an MM gets to make money on the spread here, and typically what happens causes some L2 watchers to cry. It is imperative that people use limit orders for this reason because market orders can really create money for MMs on huge spreads. The MM has an order to buy shares at the best Ask, it also sees the market order, it immediately sells shares to the Ask short and buys the market order at bid to cover. This often causes shock on both sides as somebody that was best Bid and Ask did not get filled on either order.

This is the only time MMs make money on the spread here in the OTC, otherwise it is all additional fees charged by your broker to pay for the transactions.

This is what short sales are, they are not actual short positions and they are not Abusive Naked Short Sales, they are simply trades marked short for temporary moment in time. Unfortunately the information is often touted and manipulated to make stupid conclusions of shorting against a security. In fact websites have sprung up providing this information as some type of trading knowledge to be used in making trade decisions. Unfortunately it is all fodder and is of no use to anyone other then regulators to track settlement of trades from initial execution to final settlement. I have seen it all including adding everyday totals to come up with fantastic claims that “OH MY GAWD 320% of the float has been shorted on XXXX!!!!!!!!!!!!!”

Sorry but no it hasn’t and no there will not be a short squeeze either. To answer your question in your other post on the specific board, 999,999 trades are indicative to the broker Schwab, they use USBB as a MM. Each time you see a 999,999 trade it is certain it was Schwab retail buyer. So you have answered your question, it is not specific to MM or broker and is totally dependant on the trade transaction as to whether it will be marked short or not.

Cellar boxing is myth perpetuated from back in the days, unfortunately you have people lingering around these boards that used to work the industry back in the 80s and they like to talk about how things used to be. Well we no longer sell shares by 1/8s, people buy and sell using online full service brokers for $7 as opposed to $300 a trade, and most do not hold shares in stocks for years like they used to. It is great that back in the day people used such techniques to get their ass out of trouble but they no longer apply in the electronic trading age. Did it happen, sure it was part of the environment of that trading period, but it no longer applies here in the electronic market place.

So here is the best answer.