NAKED SHORTS CAN’T STAY NAKED FOREVER

Part 3

Who engages in massive trades in penny stocks on the industry’s own “chill list”? And what happens when you sell a stock you don’t have? Victimized investor Chris DiIorio finds the answers in plain sight and wonders why no one else seems to care.

A FEW YEARS into his personal quest to understand how he had lost a million dollars on a penny stock, Chris DiIorio developed a sweeping hypothesis involving Knight Capital, the mammoth brokerage company that frequently traded in them.

Knight earned $333 million in pre-tax profits in 2008, and another $232 million in 2009. But DiIorio didn’t think Knight was making that kind of money simply from executing transactions for clients.

As a market maker, Knight was in the rare position of being able to legally sell a stock it didn’t have (the principle being that it will get that stock soon, so no worries). That’s called naked shorting. It’s illegal when regular people do it.

DiIorio suspected that Knight, either on its own behalf or on behalf of clients, made a practice of artificially increasing the number of shares available in a stock through naked shorting, thereby depressing the price.

His suspicion grew when he noticed that Knight often traded in securities that were red-flagged on the Depository Trust Company’s “chill list.”

The DTC is an obscure financial industry-owned company that manages the custody of more than $1 quadrillion in securities annually, recording the transfers with journal entries and guaranteeing the trade. The company makes it easy for people to buy and sell securities without needing to exchange paper stock.

But when the DTC senses trouble, it will stop clearing trades on a stock temporarily.

A chilled stock can still trade — as long as the market participants handle the physical certificates themselves. But it can be a sign that something is gravely wrong. The DTC states on its websitethat it chills stocks “when there are questions about an issuer’s compliance with applicable law.”

Read on.

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