The Case for the Share Standard – Part II
In Part I, I described the Share Standard as the principle that every transaction relating to corporate stock should be backed by actual shares of that stock. I believe that implementation of the Share Standard would prevent the kind of meltdown we have recently experienced. Indeed, I submit that much of the nonproductive speculation infecting the markets is the result of the Share Standard not applying. And, more important, I believe that the attendant mischief, once tolerable because not sufficiently scaled to do damage, has become intolerable with advances in financial and information technology.
Before making the policy argument, I want to continue to catalog the most common stock transactions and their status under the Share Standard. So far, we've seen that purchases and sales of stock actually owned satisfy the Share Standard. Covered calls also satisfy the Standard, but only so long as they remain covered, i.e., for so long as the writer holds the shares subject to the call. Thus, if the Share Standard were in effect, covered calls would have to be sold with the shares to which they relate as a single package, or the call would have to be repurchased before the shares are sold.
It is also clear that “naked” short selling – selling shares that the seller has not even borrowed – violates the Share Standard. But what about traditional short selling? Here an analogy to the gold standard may be useful. Under the gold standard, I can issue money that can be redeemed for gold if I own the gold and have not issued more money than I have gold. Suppose, though, that I wanted to issue money against borrowed gold. Sounds odd, but if the owner gives me custody and control of the gold, and permission to redeem money with it, I could issue good money against that gold.
Traditional short selling meets this model because the borrower does get title and thus the power to deliver the borrowed shares. The shares are tied up against being used to support other other transactions (other than subsequent sale by the buyer). So long as only one person can use the shares to support a net zero position (one long and one short), so that the net long position of all trades equals the net shares outstanding, the Share Standard is satisfied. And short selling meets that test.
Returning to derivatives, put options follow the same logic as call options. A “covered” put - a put against shares one owns - is within the Standard, but a naked put - the right to sell shares one does not own (unless one owns a call against them) - is not. This is where the Share Standard begins to pay its way as a mischief deterrent. A put is to a company's shares what a credit default swap is to its debt. Indeed, one imagines that the defense offered for the issuance of naked credit default swaps was that they were like naked puts, and “everyone knows” that naked puts are OK; they've been around for years. But a naked CDS is simply an insurance policy on the life of a company in which the holder has no insurable interest, so a naked put must be the same thing. Even if the technology doesn't exist to exploit the moral hazard in naked puts – or the naked CDS provided a better opportunity – the complete lack of benefit to the "society” (i.e., the market), suggests that naked puts should be banned.
The systemic damage done by credit default swaps is greater than the damage done by naked puts because credit default swaps do not have market-based counterparties. When I buy a put, someone else sells one. The sellers of puts are diffuse, so the risk of loss is diffuse. With credit default swaps, one seller may be responsible for billions of dollars of risk. But systemic damage can be done through effects other than concentrated risk. The “innocent” victims of naked CDS contracts are the companies on whose “lives” they are issued. Those companies became attractive targets for bear raids, implemented through transactions that could not have occurred if the Share Standard had been in force.
To put the matter another way, there is every reason to believe that naked CDS contracts created an incentive for unscrupulous traders to mount bear raids on innocent companies with the object of using a drop in their stock price to call into question their credit ratings, which would start a death spiral for the company and make the short sales and the CDS contracts pay off handsomely, at least if the party writing the CDS honored them. But if naked CDS contracts can cause this sort of damage to third parties, the fact that they are analogous to naked puts suggests that naked puts are themselves subject to manipulation.
It may be that the scale of the options market makes it impractical to buy enough puts to justify a bear raid, but that ignores the fact that a bear raid provides its own reward, so that the naked put is just gravy. In any event, I'm not aware of a “good” use for a naked put that cannot be served by some other device that conforms to the Share Standard, so I don't know why they would be allowed except for the inconvenience of policing a ban.
I should point out that my concern here is precluding mischief, not preserving conceptual purity. Thus, I would not argue that the Share Standard apply to transactions in ETFs or investment companies. Such entities are petty much immune to bear attacks and short squeezes, and all the other things that can go wrong if the Share Standard is not enforced.
Which brings me to the best thing about the Share Standard: whereas it is a radical change in the regulatory environment, it is not a complex and intrusive regulation. A list of barred transactions and exempt securities is all that would be required. (The exempt securities list is important. Just as fiat money expands the opportunities for economic growth, the ability to bet for or against the market, or business sectors may add liquidity and equilibrium to the overall market. At least, I would be open to someone making that case, because the opportunities for mischief are dramatically reduced by imposing the Share Standard on individual stocks.
Update, 5/24/10. Germany seems to be getting the idea. Javol!