The thing about naked short sales is they can’t stay naked forever.
Even if you don’t have the stock when you sell it, at some point it is expected that you hand it over.
And even with its market-maker exemption, Knight is required by SEC rules to eventually deliver the shares in a naked short transaction to the buyer and close out the trade.
Not doing so results in a “fail to deliver,” which DiIorio describes as the securities version of an IOU. And that IOU comes with rules: Under the SEC’s Regulation SHO, short sellers have to cough up the stock within one day of incurring the fail. Routine failures to deliver can lead to fines by the SEC, or even a ban from the securities markets.
Instead of complying with the rule, however, DiIorio alleges that Knight circumvented it by manipulating an obscure process within the machinery of the nation’s clearing system known as the “Obligation Warehouse.”
This service facilitates the matching of self-cleared trades (often known as “ex-clearing”) that don’t go through the DTC — for instance if the stock was chilled.
The Obligation Warehouse instead simply asks the buyer and seller of these ex-cleared trades if they “know” the transaction. If they both agree, the trade gets confirmed with a journal entry — and the buyer receives their stock purchase. It actually shows up in the buyer’s brokerage account.
The trades still have active IOUs, but according to DiIorio’s theory, buyers wouldn’t clamor for the trades to be closed because they would’ve already received their purchase.
If true, this would allow Knight to bury its naked short trades.
“They set up a shadow clearing system,” DiIorio said.
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