TL;DR- The DTC has been taken over by big money. They transitioned from a manual to a computerized ledger system in the 80s, and it played a significant role in the 1987 market crash. In 2003, several issuers with the DTC wanted to remove their securities from the DTC’s deposit account because the DTC’s participants were naked short selling their securities. Turns out, they were right. The DTC and it’s participants have created a market-sized naked short selling scheme. All of this is made possible by the DTC’s enrollee- Cede & Co.
The events we are living through RIGHT NOW are the 50-year ripple effects of stock market evolution. From the birth of the DTC to the cesspool we currently find ourselves in, this DD will illustrate just how fragile the House of Cards has become.
We’ve been warned so many times… We’ve made the same mistakes so. many. times.
In case you’ve been living under a rock for the past few months, the DTCC has been proposing a boat load of rule changes to help better-monitor their participants’ exposure. If you don’t already know, the DTCC stands for Depository Trust & Clearing Corporation and is broken into the following (primary) subsidiaries:
Depository Trust Company (DTC) – centralized clearing agency that makes sure grandma gets her stonks and the broker receives grandma’s tendies
National Securities Clearing Corporation (NSCC) – provides clearing, settlement, risk management, and central counterparty (CCP) services to its members for broker-to-broker trades
Fixed Income Clearing Corporation (FICC) – provides central counterparty (CCP) services to members that participate in the US government and mortgage-backed securities markets
Briefhistorylesson: I promise it’s relevant (thislinkprovides all the info that follows).
The DTC was created in 1973. It stemmed from the need for a centralized clearing company. Trading during the 60s went through the roof and resulted in many brokers having to quit before the day was finished so they could manually record their mountain of transactions. All of this was done on paper and each share certificate was physically delivered. This obviously resulted in many failures to deliver (FTD) due to the risk of human error in record keeping. In 1974, the Continuous Net Settlement system was launched to clear and settle trades using a rudimentary internet platform.
In 1982, the DTC started using a Book-Entry Only (BEO) system to underwrite bonds. For the first time, there were no physical certificates that actually traded hands. Everything was now performed virtually through computers. Although this was advantageous for many reasons, it made it MUCH easier to commit a certain type of securities fraud- naked shorting.
One year later they adopted NYSE Rule 387 which meant most securities transactions had to be completed using this new BEO computer system. Needless to say, explosive growth took place for the next 5 years. Pretty soon, other securities started utilizing the BEO system. It paved the way for growth in mutual funds and government securities, and even allowed for same-day settlement. At the time, the BEO system was a tremendous achievement. However, we were destined to hit a brick wall after that much growth in such a short time.. By October 1987, that’s exactly what happened.
If you’re wondering where the birthplace of High Frequency Trading (HFT) came from, look no further. The same machines that automated the exhaustively manual reconciliation process were also to blame for amplifying the fire sale of 1987.
The last sentence indicates a much more pervasive issue was at play, here. The fact that we still have trouble explaining the calculus is even more alarming. The effects were so pervasive that it was dubbed the 1st global financial crisis
Here’s another great summary published by the NY Times: *”..*to be fair to the computers.. [they were].. programmed by fallible people and trusted by people who did not understand the computer programs’ limitations. As computers came in, human judgement went out.” Damned if that didn’t give me goosiebumps… ____________________________________________________________________________________________________________
Notice the last sentence? A major factor behind the crash was a disconnect between the price of stock and their corresponding derivatives. The value of any given stock should determine the derivative value of that stock. It shouldn’t be the other way around. This is an important concept to remember as it will be referenced throughout the post.
In the off chance that the market DID tank, they hoped they could contain their losses with portfolio insurance. Another article from the NY times explains this in better detail. ____________________________________________________________________________________________________________
A major disconnect occurred when these futures contracts were used to intentionally tank the value of the underlying stock. In a perfect world, organic growth would lead to an increase in value of the company (underlying stock). They could do this by selling more products, creating new technologies, breaking into new markets, etc. This would trigger an organic change in the derivative’s value because investors would be (hopefully) more optimistic about the longevity of the company. It could go either way, but the point is still the same. This is the type of investing that most of us are familiar with: investing for a better future.
I don’t want to spend too much time on the crash of 1987. I just want to identify the factors that contributed to the crash and the role of the DTC as they transitioned from a manual to an automatic ledger system. The connection I really want to focus on is the ENORMOUS risk appetite these investors had. Think of how overconfident and greedy they must have been to put that much faith in a computer script.. either way, same problems still exist today.
Finally, the comment by Bruce Bartlett regarding the mismatched investment strategies between stocks and options is crucial in painting the picture of today’s market.
Now, let’s do a super brief walkthrough of the main parties within the DTC before opening this can of worms.
I’m going to talk about three groups within the DTC- issuers, participants, and Cede & Co.
Issuers are companies that issue securities (stocks), while participants are the clearing houses, brokers, and other financial institutions that can utilize those securities. Cede & Co. is a subsidiary of the DTC which holds the share certificates.
Participants have MUCH more control over the securities that are deposited from the issuer. Even though the issuer created those shares, participants are in control when those shares hit the DTC’s doorstep. The DTC transfers those shares to a holding account (Cede & Co.) and the participant just has to ask “May I haff some pwetty pwease wiff sugar on top?” ____________________________________________________________________________________________________________
Now, where’s that can of worms?
Everything was relatively calm after the crash of 1987…. until we hit 2003..
The DTC started receiving several requests from issuers to pull their securities from the DTC’s depository. I don’t think the DTC was prepared for this because they didn’t have a written policy to address it, let alone an official rule. Here’s the half-assed response from the DTC:
Realizing this situation was heating up, the DTC proposed SR-DTC-2003-02..
Honestly, they were better of WITHOUT the new proposal.
It became an even BIGGER deal when word got about the proposed rule change. Naturally, it triggered a TSUNAMI of comment letters against the DTC’s proposal. There was obviously something going on to cause that level of concern. Why did SO MANY issuers want their deposits back?
UHHHHHHH WHAT!??! Yeah! I’d be pretty pissed, too! Have my shares deposited in a clearing company to take advantage of their computerized trades just to get kicked to the curb with NO WAY of getting my securities back… AND THEN find out that the big-d*ck “participants” at your fancy DTC party are literally short selling my shares without me knowing….?!
….This sound familiar, anyone??? IDK about y’all, but this “trust us with your shares” BS is starting to sound like a major con.
The DTC asked for feedback from all issuers and participants to gather a consensus before making a decision. All together, the DTC received 89 comment letters (a pretty big response). 47 of those letters opposed the rule change, while 35 were in favor.
To save space, I’m going to use smaller screenshots. Here are just a few of the opposition comments..
Here’s the full list if you wanna dig on your own.
…I realize there are advantages to “paperless” securities transfers… However… It is EXACTLY what Michael Sondow said in his comment letter above.. We simply cannot trust the DTC to protect our interests when we don’t have physical control of our assets**.**
Several other participants, including Edward Jones, Ameritrade, Citibank, and Prudential overwhelmingly favored this proposal.. How can someone NOT acknowledge that the absence of physical shares only makes it easier for these people to manipulate the market….?
This rule change would allow these ‘participants’ to continue doing this because it’s extremely profitable to sell shares that don’t exist, or have not been collateralized. Furthermore, it’s a win-win for them because it forces issuers to keep their deposits in the holding account of the DTC…
Want proof of market manipulation? Let’s fact-check the claims from the opposition letters above. I’m only reporting a few for the time period we discussed (2003ish). This is just to validate their claims that some sketchy sh*t is going on.
pg 550; FAILURE TO REPORT SHORT SALE TRANSACTIONS WITH INDICATOR; 9/28/1999
pg 507; SHORT SALE VIOLATION; 11/21/1999
pg 426; FAILURE TO REPORT SHORT SALE MODIFIER; 1/21/2003
Ironically, I picked these 3 because they were the first going down the line.. I’m not sure how to be any more objective about this.. Their entire FINRA report is littered with short sale violations. Before anyone asks “how do you know they aren’t ALL like that?” The answer is- I checked. If you get caught for a short sale violation, chances are you will ALWAYS get caught for short sale violations. Why? Because it’s more profitable to do it and get caught, than it is to fix the problem.
Wanna know the 2nd worst part?
Several comment letters asked the DTC to investigate the claims of naked shorting BEFORE coming to a decision on the proposal.. I never saw a document where they followed up on those requests…..
NOW, wanna know the WORST part?
The DTC passed that rule change….
They not only prevented the issuers from removing their deposits, they also turned a ‘blind-eye’ to their participants manipulative short selling, even when there’s public evidence of them doing so…
….Those companies were being attacked with shares THEY put in the DTC, by institutions they can’t even identify…
The DTC started using a computerized ledger and was very successful through the 80’s. This evolved into trading systems that were also computerized, but not as sophisticated as they hoped.. They played a major part in the 1987 crash, along with severely desynchronized derivatives trading.
In 2003, the DTC denied issuers the right to withdraw their deposits because those securities were in the control of participants, instead. When issuer A deposits stock into the DTC and participant B shorts those shares into the market, that’s a form of rehypothecation. This is what so many issuers were trying to express in their comment letters. In addition, it hurts their company by driving down it’s value. They felt robbed because the DTC was blatantly allowing it’s participants to do this, and refused to give them back their shares..
It was critically important for me to paint that background.