CMKM Diamonds Inc (fka CMKX)

[jetfish]

Vodia Group LLC

Extracted from Josh Galper's primer

Managing Principal

Vodia Group LLC

April 17, 2006

http://www.vodiagroup.com/pdfs/seclending1.pdf

The Lawsuit

The lawsuit alleges that Prime Brokers have allowed their clients to
illegally short stock without having the security in hand, also called naked shorting. Naked shorting is agreed to be a bad thing by pretty much every regulated participant in the industry, at least in a public forum. Typically hedge funds are made into the bad guys in naked shorting because they are the holders of the shorted positions. Not to shed tears for the hedge funds, but in fact they can not short stock illegally without their broker's consent.

The lawsuit says that the 11 Prime Brokers named effectively told their clients that they had stock, allowed their clients to short the stock, then did not deliver the stock as promised, leading to a naked short position. By naming all 11 major Primes as defendants, the plaintiffs are effectively saying that broker-driven naked shorting is an established industry practice.

In addition to simply allowing naked shorting, the hedge funds allege that the Primes charged for services they did not deliver. The funds allege that while they were charged, often up to 25% in interest for the right to borrow rare or in-demand securities, they did not receive any services in return.

If they did not receive services such as delivery of the actual stock
available to borrow, then, they say, they should not have been charged. The allegation is that the brokers used their positions of influence to manipulate the securities lending system for their own benefit.



The Mechanics of Naked Shorting and Borrowing Stock

While it is not our place to comment whether or not the lawsuit has merit, or if and who is responsible for naked shorting, there are some facts that are clear. For example, if broker-sanctioned naked shorting is or was occurring, how it is done can be explained.

In a naked short, a broker allows a fund to short a stock without having the stock in hand. This creates a failure in clearing and settling a stock and is frowned on by the SEC. Recently the SEC strongly suggested that naked shorting is bad practice by passing Regulation SHO. Among other things, Reg SHO gave firm deadlines for when excessive naked short positions had to be bought in (closed out) in the form of a Threshold List. Notably, SHO does not address the reasons that brokers fail to locate shorts or deliver stock.

It simply mandates that brokers must get the stock delivered in certain timeframes.

In shorting a stock, there is a concept known as an affirmative or
guaranteed locate. This means that before shorting, a hedge fund must know concretely who holds the stock that it wants to short and be approved by that firm for shorting their position. In practice, most hedge funds call their Prime Broker Securities Lending desk (known in equities as "Stock Loan"). This back office trading desk tells the fund whether or not they have their stock for shorting. In the lingo, they confirm whether or not a "locate is good." If a locate is good, even verbally, the hedge fund is cleared to trade. It is the Prime's responsibility to ensure that they make good on the verbal agreement to deliver the lendable security to the hedge fund's account.

So what happens if the Prime does not give the hedge fund their stock at the end of the day, even if they said their locate was good? The hedge fund shorts the stock and the Prime notes a short position that needs to be covered either from their inventory, from a friendly custodian or by calling around to other Prime Broker desks. Often the stock is not found and the Prime may choose to let it go for a while. Other times the stock is found and the Prime fills the hole in their position, or the Prime does not borrow the stock but knows that it can access that inventory at any time because of their relationship with the asset holder.

As an example of a broker-sanctioned naked short, say hypothetically that a hard to borrow stock carrying a negative rebate rate (borrower pays the lender) was verbally guaranteed to one hedge fund at 11AM. At that time the Prime held the stock in hand. Then at 3PM, another hedge fund came and asked for the same stock. The Prime guarantees the second fund the stock and creates the conditions for the first fund to have a naked short position.

The Prime is now receiving a negative rebate rate (getting paid to lend the stock out) by both funds. Both funds have done their required due diligence by verifying with their Prime that the locate was good.



The Prime now goes to locate the remaining stock at an inventory supplier.

The Prime may have guaranteed access to a portfolio of securities at a custodian or retail broker dealer as part of a master agreement between the two firms. The Prime knows that the security is available for loan but elects not to take the security in house, because that would force the Prime to pay out a negative rebate rate to the asset holder, or may be able to coerce the asset holder to give them the stock without payment. A week later, the first borrowing hedge fund covers (closes out) its position and completes the transaction without the Prime ever having borrowed the stock from the asset holder. To run through the outcomes for the players:

* The Prime gets revenues twice (from the first fund and the second fund) but violates industry regulations and best practice by allowing a naked short

* The first fund pays for services that were not rendered and has shorted stock illegally

* The second fund pays fairly for the services it received

* The custodian or retail broker dealer loses out on revenues it could have earned if the stock were lent and a negative rebate paid

* The actual owner of the assets, typically an individual or a pension plan, gets nothing

By failing to deliver stock to the first borrowing hedge fund, the Prime creates a failure in the clearing and settlement process. Primes could have a number of ways to plug this hole, ranging from creating IOUs on fails with counterparties, creating options around the fail, or creating contracts for differences on the fail. All of these new financial instruments may have value in the marketplace. However, if used, none accurately enable a Prime to meet their obligations in the securities settlement process.

Again, we can not judge whether or not this has been occurring or in how many firms. The lawsuit alleges that this is industry practice, and whether it is or is not is a matter for the courts to decide.…..

About Vodia Group LLC

Vodia Group is a consulting firm focused on financial services and financial technology. Our strengths include strategic consulting, due diligence, new business development and mergers and acquisitions. We also produce data-driven research on the industry, including a recent report on unbundling in prime brokerage and the future of US Regional Stock Exchanges.