Revealing Brokerage Secrets; Should Short Selling Be Restricted?

Marin Katusa  |

Pixabay, Olya Adamovich

Last week I published a piece on the practice of short selling.

And I often get asked if I think short selling is good for the market.

I believe in an open market…

But I also believe that if we are all playing the same game (the stock market) both the longs and shorts should be playing by the same set of rules.

It’s that simple.

A lot of people are blaming the exchanges. But the brokerage firms are part of the problem also. With the reduction in retail trading commissions, brokerage firms have had to figure out ways to generate new fees.

Lending out their client's stock, and keeping 100% of the proceeds, is just morally wrong.

Yet, I know it happens.

The exchange knows it happens, too. Few clients with brokerage accounts, however, know this happens.

But it’s totally legal.

Because there is a very small clause in the fine print (which almost nobody reads when they open an account), that if you have an account and tick off the margin box, the brokerage firm is allowed to lend your stock out without asking you. And the brokerage firm keeps 100% of the profits of lending the stock to your shorts.

Think About How Stupid That Is...

There will be a syndicate that will figure out which stocks are prime for short squeezes.

And they can coordinate with the clients to pull the shares out of the brokerage account (the only legal right the clients have).

Then the shorter who borrowed the stock will have to cover or find a new borrow from another firm.

This is an incredible opportunity, and the beauty of the open market is someone will figure it out.

But this leads us to an important question…

Where Does Borrowed Stock Come From?

The basic answer is you and me. And without us even knowing about it.

Let’s take ABC Corp for example…

The stock is lent out from the brokerage house, say in this example, PaytheWood Securities Ltd where our ABC shares reside (retail and institutional).

Many brokerage houses are borrowing the stock from margin accounts of their clients without the clients knowing.

And the brokerage houses are making lots of money on lending the shares out to the shorter for a fee. It can be as high as a 30% borrowing cost.

The brokerage houses never give the ABC shareholder the information that it’s the client’s shares that have been lent out short.

Nor that the brokerage house is making money on loaning the ABC shareholders stock out!

Here’s the snowball effect:

The “Shorters” use the ABC shareholder stock position available in the margin brokerage accounts to drive the price down.

Then the shareholder panics because he experiences such a drastic drop in the share price.

And then the ABC shareholder sells his stock at a low price to the shorter who covers his short.

Not to mention a couple of newsletter writers have an automatic 50% stop loss rule that plays exactly into the ‘Short & Distort’ strategy.

How can this be stopped?

The only way I know is if the shareholders of any company that is being shorted does not allow their stock to be borrowed.

When you open your account, you have to specifically state this.

Also, you actually have to sign forms if you already have an account to prevent the brokerage firm, like the fictional PaytheWood from lending your stock out.

It’s absurd, but it’s the new world we live in.

The shorter would then have to pay higher rates to borrow the stock. This is because there is less stock available to borrow in the system.

  1. The first thing the exchanges should do is force the brokerage firms to send the clients whose stock is being borrowed an approval form—to agree or disagree whether their stock is to be borrowed
  1. The client should get the bulk of proceeds made for their stock being loaned out—and that should be pre-agreed upon before the client agrees in Step 1 above

I have no issues with shorting.

I have an issue with the game of shorting and then distorting the investment thesis with lies. The exchange should come down hard on those dirty players. It’s no different than going after the pump and dumpers.

How You Can Limit Short Selling and Fees Off Your Back

Here's a simple solution for the retail crowd. If you don’t want your shares ever to be lent out without your approval then you can segregate your shares of the stocks you own.

This way your stock can’t be loaned. And it would force the ‘Short & Distort’ syndicates to have to start buying and covering shares.

This would cause a significant increase in the share price.

I want to make it very clear I am not trying to put out any manipulation theory here.

I can see a ‘Short & Distort’ syndicate using my comments and distorting my own intention of educating my subscribers to the reality of Wall/Bay/Howe Street.

What a shareholder can do is tell his broker:

I don’t want my stock loaned out, segregate it!

And get it in writing.

This is what I’ve told my brokers:

I don’t want my stock loaned out, segregate it.

Put it into an account that is not linked to any other account that has or could have any margin in it. If I don’t have such an account please set one up. Please confirm back to me by email that the stock is now in an account where it cannot be loaned. If you cannot do this for me right away, I hereby demand physical delivery of a certificate representing my shares as soon as possible and shut down my account.

It was a seamless experience, and my broker did as I asked him. When I first did this, my broker stated he has never had anyone request that from him. He is one of the largest brokers at a firm that does some of the most lending. What a world we live in.

With the online brokerage accounts where one has margin, I am not sure what the solution is. Is this how the brokerage accounts subsidize their low trading fees?

Interesting thought that nobody has surmised this before.

‘Short & Distort’ is active in the resource sector because the industry has a heavy percentage of retail shareholders and they are being used by the industry. And the ‘Short & Distort’ crowd looks to take advantage of the retail shareholders.

Not with this Alligator!

It’s the brokerage firms who are making a lot of money on this:

  • Interest on the borrow,
  • Commission on the short sale,
  • Commission on the short cover and
  • Commission on the shareholder selling in despair.

It’s a dirty secret in the business that nobody is talking about.

But I wanted readers to be aware of what I believe the situation to be and how best to protect yourself and your shares.

_____

Equities Contributor: Marin Katusa

Source: Equities News

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.


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