FTDs and the Locate Loophole

In Part 6, we explained short selling: borrow shares, sell them, buy them back later at a lower price. Simple enough. But what if you don't actually borrow the shares? What if you just... sell them anyway?

The Settlement System: How It's Supposed to Work

When you buy stock, you expect to receive shares. When you sell, you expect to deliver them. The settlement system makes this happen.

The Players

DTCC (Depository Trust & Clearing Corporation): The parent company overseeing the settlement infrastructure.

NSCC (National Securities Clearing Corporation): The clearinghouse that acts as the counterparty to both sides of every trade. When you buy, you're technically buying from NSCC. When you sell, you're selling to NSCC. This guarantees that both parties fulfill their obligations.

DTC (Depository Trust Company): The vault that holds virtually all U.S. securities in electronic form. When you "own" stock, you really own an entry in DTC's books.

Continuous Net Settlement (CNS)

The NSCC's CNS system is the core of settlement. Investopedia explains:

"NSCC member positions in each issue are netted into a single long position and a single short position at the end of the day."

Rather than settling every individual trade, CNS nets positions. If Fidelity clients buy 1 million shares of Apple and sell 900,000 shares, Fidelity's net position is +100,000 shares. Only this net amount needs to actually move.

This netting reduces the volume of shares that must physically transfer by about 98% — making the system efficient. But it also creates opacity: individual trades disappear into aggregated positions.

T+1 Settlement

As of May 2024, trades settle T+1 — one business day after the trade. If you buy on Monday, settlement occurs Tuesday.

Settlement means:

• Cash moves from buyer to seller
• Shares move from seller to buyer
• Ownership officially transfers

But what happens when shares don't arrive?

Failures to Deliver: When Settlement Fails

A failure to deliver (FTD) occurs when the seller doesn't deliver shares to the buyer by settlement date. The trade remains open — the buyer has paid, but hasn't received what they bought.

Why FTDs Happen

FTDs can result from:

1. Legitimate operational issues: Processing errors, miscommunication, administrative delays
2. Hard-to-borrow stocks: The seller legitimately sold short but couldn't find shares to borrow
3. Naked short selling: The seller sold shares they didn't have and didn't borrow — hoping to find shares later or never deliver at all

The SEC acknowledges: "Fails-to-deliver can occur for a number of reasons on both long and short sales." Not every FTD indicates manipulation.

But persistent, large-scale FTDs in specific stocks often signal something problematic.

The Threshold Securities List

Regulation SHO, adopted in 2005, created the threshold securities list — stocks with significant FTD problems. A security lands on this list when:

• FTDs total 10,000 shares or more for five consecutive settlement days
• FTDs equal at least 0.5% of total shares outstanding

Stocks on the threshold list face additional close-out requirements. Broker-dealers must close out FTD positions within 13 consecutive settlement days.

The problem? Companies can remain on the threshold list for months, even years. As economist John Welborn of Dartmouth observed: "There is no lawful way for a stock to be on the threshold list for months. The only explanation is regulatory apathy, or worse."

Naked Short Selling: Selling What You Don't Have

Naked short selling means selling shares without first borrowing them or ensuring they can be borrowed. It's short selling without the "short" part — just selling shares that don't exist.

Wikipedia's definition is precise:

"Naked short selling, or naked shorting, is the practice of short-selling a tradable asset without first borrowing the asset from another party or ensuring that it can be borrowed. When the seller does not obtain the asset and deliver it to the buyer within the required settlement period, the result is known as a 'failure to deliver.'"

Why It Matters

When you naked short:

1. You sell shares that don't exist
2. The buyer receives an IOU, not real shares
3. If done at scale, this dilutes the company's float with "phantom shares"
4. The selling pressure drives down the price — without any actual shares changing hands

Critics argue naked shorting creates artificial supply, depressing prices beyond what fundamental selling would achieve. Robert Shapiro, former undersecretary of commerce, has claimed that naked short selling "has cost investors $100 billion and driven 1,000 companies into the ground."

The Counterargument

Some academics and regulators argue the effects are overstated. A 2014 study in the Journal of Financial Economics found that FTDs "did not cause price distortions or financial firms' failures during the 2008 financial crisis" and actually "increased liquidity and pricing efficiency."

The SEC itself has stated that concerns about "phantom" or "counterfeit" shares are exaggerated, and that naked shorting "would not increase a company's outstanding shares."

Who's right? The truth likely depends on the specific situation. Occasional FTDs from operational issues are benign. Sustained, large-scale FTDs concentrated in specific stocks raise legitimate concerns.

The Locate Loophole

Regulation SHO requires broker-dealers to "locate" shares before executing a short sale. The broker must:

1. Borrow the security, OR
2. Enter into a bona fide arrangement to borrow, OR
3. Have "reasonable grounds to believe" the security can be borrowed

That third option — "reasonable grounds to believe" — is the loophole. Brokers can satisfy the locate requirement with a belief, not an actual borrow.

How the Loophole Works

A broker might maintain an "easy to borrow" list of liquid stocks. If a stock is on this list, the broker has "reasonable grounds" that shares will be available, and the short sale can proceed without an actual locate.

But the same shares can be "located" multiple times. If ten different clients want to short a stock, and the broker has located 1,000 shares, all ten might be told shares are available — even though there aren't enough for everyone.

The DTCC's Role

The DTCC has historically resisted reforms that would increase transparency. As reported in The American Prospect:

"The DTCC has historically beaten back attempts to reveal naked short selling culprits, or even to tag 'borrowed' shares (called the hard borrow) so they can't be 'located' more than once."

A centralized database tracking which shares are actually borrowed would prevent multiple locates of the same shares. Such a database has been proposed but never implemented.

The Market Maker Exception

Here's where it gets really interesting: market makers are exempt from the locate requirement.

FINRA's 2023 examination guidance confirms:

"Rules 203(b) (Short sales) and 204 (Close-out requirement) of Regulation SHO provide exceptions for bona fide market making activity."

The rationale is that market makers need to sell shares they don't own to provide liquidity. If a buyer wants shares and no seller is available, the market maker sells them short to fill the order — maintaining continuous markets.

The Abuse Potential

The market maker exception creates obvious abuse potential:

1. Claim to be engaged in "bona fide market making"
2. Short shares without locating them
3. Generate FTDs
4. Argue the rules don't apply

What constitutes "bona fide market making"? FINRA found firms claiming the exception while:

• Quoting only at maximum allowable distances from the market (not really making a market)
• Posting quotes only on one side (bids or asks, not both)
• Only posting quotes when they have an order (not continuously)

These aren't genuine market-making activities — they're using the exception to naked short.

Reforms and Remaining Gaps

The options market maker exception was narrowed in 2008, requiring that hedging transactions be for options positions established before a stock went on the threshold list. But loopholes remain.

The SEC's own Reg SHO FAQ acknowledges that enforcement is challenging. Proving that activity isn't "bona fide market making" requires examining intent — always difficult in legal proceedings.

GameStop: A Case Study in FTDs

The GameStop saga in January 2021 brought FTDs into public consciousness.

The Numbers

At its peak, GME had:

• Short interest of 140% of the float — more shares sold short than actually existed
• FINRA reported short interest reached 226% of float during the frenzy
• The stock spent 39 days on the threshold securities list between December 2020 and February 2021

Goldman Sachs later noted that short interest exceeding 100% of a company's public float had occurred only 15 times in the prior 10 years. GME was exceptional.

The Implications

How can short interest exceed 100%? The SEC's report explains:

"That is, there will be one share sold short twice, and so short interest will be 2%, even though 99 of the 100 shares are not being sold short."

When shares are borrowed and sold, the buyer can lend them again. The same share can be borrowed multiple times. This is legal and normal — to a point.

But 140%+ short interest, combined with massive FTDs and extended threshold list presence, suggests something beyond normal market function. As The American Prospect analyzed:

"With short interest well above 100 percent of the float, there were not enough real shares to borrow. That is why there were fails to deliver to the buyers."

The Aftermath

The SEC's October 2021 staff report analyzed GME but declined to conclude that naked shorting caused the problems. The report noted that FTDs "can occur for a number of reasons" and that the data doesn't definitively prove manipulation.

Critics argue this was a missed opportunity for enforcement. The patterns were clear; the will to act was absent.

Phantom Shares and Over-Voting

One consequence of persistent FTDs: over-voting in corporate elections.

When FTDs exist, both the original owner and the buyer believe they own shares. If both vote in a shareholder meeting, more votes are cast than shares exist.

Dr. Susanne Trimbath, author of Naked, Short and Greedy and a former DTCC employee, has documented this phenomenon extensively. Companies have reported receiving more proxy votes than outstanding shares — mathematically impossible if the share count is accurate.

The Proxy System's Response

Rather than investigate over-voting as evidence of FTDs, the proxy system typically just scales down votes to match the share count. The symptom is treated; the cause is ignored.

This means:

1. FTDs create phantom shares
2. Phantom shares generate phantom votes
3. Proxy companies quietly adjust totals
4. No one investigates the underlying problem

Why Enforcement Lags

Given the rules exist, why does naked shorting persist?

Resource Constraints

The SEC has limited resources relative to the scale of modern markets. Investigating FTD patterns requires sophisticated data analysis across millions of trades.

Regulatory Capture

The financial industry heavily lobbies regulators and staffs them with industry veterans. The revolving door between Wall Street and Washington creates reluctance to pursue aggressive enforcement.

Complexity and Deniability

Proving naked shorting requires demonstrating intent — that a seller knew shares couldn't be borrowed and sold anyway. Market makers can claim bona fide exceptions. Brokers can point to their easy-to-borrow lists. Intent is hard to prove.

Penalties Don't Deter

When enforcement does occur, penalties are often trivial. Citadel Securities has been fined 58 times for trading violations, many involving short selling rules. The fines are cost of doing business — not deterrents.

What This Means for You

1. Understand that the system tolerates what it should prevent.
FTDs and naked shorting aren't theoretical — they occur regularly. The rules exist but enforcement is weak.

2. Be cautious with heavily shorted stocks.
When short interest approaches or exceeds 100% of float, the normal rules of supply and demand may not apply. Prices can move on phantom supply.

3. Check the threshold list.
If a stock you own is on the threshold securities list, that's a warning sign of settlement problems. It doesn't mean you should sell, but you should understand what it implies.

4. Recognize the GME pattern.
When social media hypes a heavily shorted stock, understand the mechanics. Short squeezes are real, but so is the manipulation that can follow.

5. Don't expect regulators to protect you.
The SEC and FINRA set rules but struggle to enforce them. Your protection comes from your own understanding and skepticism.

Looking Ahead

We've explored the dark corners of market structure — manipulation tactics and the settlement failures that enable them. Now let's turn to something you can actually use.

In Part 9, we'll cover how to follow the motives — reading 13F filings, tracking short interest, understanding insider transactions, and separating signal from noise. The information is public; you just need to know where to look.