The Risks Remain

by Kevin D. Freeman on June 28, 2011

The highly respected publication, The Economist, published an article on June 2 that outlines continuing risks in the U.S. financial markets. The article is titled ”America’s dodgy financial plumbing,” and outlines the risks of naked short selling in its various forms. The article is very clear that “unsettled trades” have the potential for systemic risks. This is very much in line with the original findings of the DoD report. In fact, this article actually mentions the report with the following comment:

“Brows are even furrowed at the Pentagon. A report on economic warfare that it commissioned in 2009 gave warning that settlement flaws could be used by terrorists to destabilise financial systems.”

The center of the concern in this article is that naked short selling has continued to grow despite regulatory attempts to dampen it. As you can see in the chart, the market collapse in late 2008 was accompanied by a massive spike in naked short selling. The question remains whether failed to deliver trades were responsive, coincidental, or causative of the turmoil. Our analysis suggests that naked short selling played a role in the crash and may well have been a weapon used to bring down the markets. This position is supported by comments made by George Soros at the time regarding bear raids and in line with the strategic thinking outlined by the Chinese in Unrestricted Warfare. To assume that the massive spike in naked short selling is simply an anomaly is to ignore the obvious.
 

 ”Trades are settled when the seller delivers the security in return for cash, generally one-to-three days after the trade. Only then does the buyer legally own it and no longer have to worry about the seller defaulting. Though settlement is now largely electronic, it is plagued by “fails to deliver”, which happen when the seller does not produce the security on time. These have fallen back after spiking in crises, but have been persistently high of late (see chart). In 2010 America’s primary dealers reported $128 billion of fails per day on average, almost 50% higher than their combined net capital at risk, according to Fred Sommers of Basis Point Group, a consultancy.”

All in all, The Economist article makes some excellent points. Their introductory statement sums it up nicely:

“The financial crisis of 2007-09 and the “flash crash” of American stock markets in May 2010 revealed numerous faults in the plumbing. Efforts are under way to mend these, but regulators have been slow to attend to some worrying new blockages arising from today’s high-frequency and tightly coupled markets.”

All posts Copyright (c) 2011 Kevin Freeman, All Rights Reserved

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