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Glossary for Naked shorting: The curious incident of the shares that didn't exist

Definitions for: Naked short selling; Illegal naked short selling; Stock borrow programme; Fail to deliver; Margin account stock; Market maker; OTC Bulletin Board; Pink Sheets; DTCC; NSCC; Freiverkehr; Regulation SHO; Threshold Securities List; NASD Rule 3370.

Naked short selling:  Naked short selling, while not defined in the federal securities laws or SRO rules, generally refers to selling short without having borrowed the securities to make delivery.

Illegal naked short selling:  Naked short selling becomes illegal if conducted by anyone other than a "bona fide market maker", or if it is conducted by "bona fide market maker" with the intention of manipulating stock price downwards.

Stock borrow programme:  The DTCC programme authorised by the SEC in 1981 that allows broker/dealers to put money in clients' margin accounts into a central lending pool at the NSCC. Participants can request to buy-in stock from this pool if their order fails to deliver.

Fail to deliver:  Shares from a seller's brokerage account are supposed to be transferred to the account of the buyer's brokerage in return for payment by the third day following the transaction (t+3). If this does not happen the selling brokerage registers a fail to deliver. The market maker or short seller has failed to deliver.

Margin account stock:  Stock held in a margin account can come from money lent by the broker. The loan in the account is collateralised by securities and cash.

Market maker:  Market makers are broker dealers that accept the risk of holding a particular number of shares in a particular stock in order to facilitate trading. Market makers quote both bid and offer prices for a guaranteed number of shares. Once an order is received, the market maker immediately sell from its own inventory or seeks an offsetting order.

OTC Bulletin Board:  The OTCBB is a quotation medium for subscribing members, not an issuer listing service. OTCBB securities are traded by market makers that enter quotes and trade reports through a closed computer network. Unlike the Nasdaq Stock Market the OTCBB does not impose listing standards, provide automated trade executions, maintain relationships with quoted issuers, or impose the same obligations on market makers. OTCBB companies have to file quarterly with the SEC.

Pink Sheets:  Established prior to the OTC BB, the Pink Sheets are a daily publication compiled by the National Quotation Bureau containing price quotations for OTC stocks. These companies do not have to file with the SEC.

DTCC:  The Depository Trust and Clearing Corporation operates the DTC, the NSCC and the FICC (Fixed Income Clearing Corporation).

DTC:  The Depository Trust Company (DTC), retains custody of nearly all US share certificates. Its centralised system allows for shares to be transferred between accounts electronically rather than physically. The DTC is a clearing company incorporated as a limited-purpose trust company and an integral part of the US Federal Reserve System.

NSCC:  The National Securities Clearing Corporation (NSCC), is the central counterparty for nearly all broker-to-broker equity, corporate bond, municipal bond, exchange-traded fund and unit trust trades in the US. It provides centralized clearing, settlement and information services.

National Coalition Against Naked Shorting (NCANS):  A coalition of investors created by "Bob O' Brien" (a shareholder in NYSE-listed NovaStar Financial). The coalition published a $50,000 advertisement in the Washington Post in February this year calling attention to continued naked shorting. Patrick Byrne, CEO of Nasdaq-listed company Overstock.com and some small investors who believe they are victims of naked shorters contributed with O'Brien to the cost of the advertisement.

Freiverkehr:  A regulated unofficial market administered by a German exchange. A market maker can apply to trade any security that's traded on a recognised exchange anywhere in the world with minimal restrictions and conditions. Securities are not technically listed, so no issuer approval is needed for trading to take place.

Regulation SHO:  This regulation was adopted by the SEC on July 28 2004 and came into effect on January 3 2005. The regulation modifies the rules for short sales in the US with the objective of restricting naked short selling and supplants other conflicting short sale restrictions.

Rule 200 defines ownership of securities, specifies aggregation of long and short positions, and requires broker-dealers to mark sales in all equity securities "long," "short," or "short exempt".

Regulation SHO also requires short sellers in all equity securities to locate securities to borrow before selling, and also imposes additional delivery requirements on broker-dealers for securities in which a substantial number of failures to deliver have occurred (Rule 203). Equity and options market makers are exempt from these requirements when conducting bona fide market making. There are no penalties for violating Regulation SHO.

Threshold Securities List:  The Threshold Securities List is published daily by the major stock exchanges in the US -- the NYSE, Amex, Nasdaq, OTC Bulletin Board and Pink Sheets, of companies whose shares show significant and persistent fails. Any stock traded on these organisations with total fails of at least 0.5% of shares outstanding and 10,000 shares that persist for five consecutive days is a "Threshold" stock.

NASD Rule 3370:  NASD Rule 3370 requires US broker/dealers to make an affirmative determination that they will receive delivery of a security or be able to borrow that security on behalf of their clients prior to the settlement date, before accepting any short sale order. The rule was extended on April 1 2004 to include non-member broker/dealers too.


Strategic failures

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Stung by the German connection

Letters to the editor: Reader responses

  Responses:
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Larry Thompson: Defending the DTCC

- Robert J Shapiro: A case still to answer

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