Friday, October 10, 2008

Byrne's Regulatory Regime

Hmmm, my entry in the Crack the Capture essay contest has three votes. The reason it is so high is because I cheated. I told people about it, and was annoying to the point that they voted for me.

Patrick Byrne's Deep Capture project simply seeks strong regulation to assure that shorts borrow stock before they sell. In disciplined shorts, I contend that, to prevent Failure to Delivers, one must also prevent the people who've loaned their stock to short sellers from borrowing until they get their shares back.

I contend that one final element is needed to make a short regime feasible. Brokers and mutual funds must report to investors when shares are shorted.

The vast majority of people who think they own stock today don't own stock. Their broker lent their shares to a short seller. Most of the people who think they own stock are simply creditors to short sellers. People want to be invested in the market. They do not want to be creditors of short sellers.

A disciplined regulatory structure for shorts would dramatically reduce abuses of short sales, but it would all but eliminate the number of people willing to lend their shares to short sellers.

The question is if a disciplined regulatory regime is tenable.

I contend that it is not.

The first problem is that a large number of hedge funds and investors have taken to investment formulas where 30+ percent of their portfolio is short at any given moment. (NOTE I see this systematic shorting as problematic as it diverts trillions of dollars from investments into paper fluff). Regardless the formulas exists and there is now a massive demand for short positions that outstrip the demand.

Because the demand for short paper outstrips the market, a disciplined shorting regime lends itself to manipulation. The first problem is that the restricted supply of short paper will be gobbled up by hedge funds making it neigh impossible for independent investors to short.

The second problem is that it simply adds one more layer to stocks for manipulation. Since the demand for short stocks would be insatiable, hedge funds will be able to manipulate the price of stock by making short paper available or by removing it at a critical time in the buying process. For example, a hedge fund would make all of their shares in a stock available for shorting preceeding a large buy, then they would clam up after the buy.

Disciplined shorting does not prevent hedge funds from being able to artificially increase the float of a stock. For example, a firm could buy 1M shares of stock in a sector, lend that stock to themselves and short. They could then role the IOUs and the short sales into two separate instruments. The hedge fund could then sell these instruments to their customers. Their customers would think they were invested in the market, but were just invested in fluff.

The disciplined short regime would reduce problems, but at every turn regulators will find market players doing reindeer games to manipulate the market by manipulating shares poised for shorts.

Any attempt to create a disciplined short regime will fall as the rogues of the world recapture the regulatory mechanism that enforces discipline.

No comments: