Loophole in the exchanges

In my previous post here, I've talked about a loophole in the exchange which all hedge funds and shortists are taking advantage of all over the world. Just today they are finally taking a co-ordinated effort to close this hole. Whether will it be closed remains to be seen.

Let me explain about this loophole.

The exchange is based on a very simple concept (Let's not talk about the complicated portion). I have a company, and it has x number of shares in the market. I can own y shares, and the remaining z shares will be owned by the public, or institutions. But x = y + z. Therefore, since the number of shares are the same in the market (for this example, we'll take it to be the same), the buying and selling will reflect the demand of shares, hence the value of the company could be determined. That's where you start looking at the books, determining the value and its growth rate, etc.

After that, the exchanges introduced the concept of lending shares. That means for my y number of shares, I can choose to lend them out to people to contra or to short. Contra meaning that I will buy first, and sell by a certain time. Short means the opposite, where I will sell first, and buy back by a certain time. This ruling is still ok, reason being x = y + z. The total number of shares will still be x as the shares are lend out by certain shareholders, maybe to create liquidity in the market. The number of shares being constant, and the borrowing of the shares requiring some unfront cost, the value of the company would not be far off as research will still be done. If the value is below the comfortable level of the shareholders, they can always stop lending out the shares.

Now here comes the loophole. The exchanges around the world decided that this is not enough. Therefore, they introduced something called naked shorting. So what does that mean? That means that even though if someone didn't own, or borrow any shares, this person can choose to sell the shares, to bet that the shares will dive. Yes... The exchange has become a gambling den.

There comes the problem that changed the whole rules of the game. That means effectively, at some point of time, there will be a possibility that x != y + z. Shares are created out of thin air by these naked shortists because they do not need to even borrow or own the shares. Even when all the shareholders stop lending out their shares, people can still short the shares to their hearts content.

If anyone can short any company's shares as and when they like, do you think they will take time to think of this company's fundamentals, cashflow, business plan, etc? No. They will just look at the chart and just keep shorting it down as long as the chart says so. That's what happened for the past few days. News started to spread that this bank not well-capitalised, this bank merging with another bank because it's in trouble, etc. It became a self-fulfilling policy because suddenly all the mark-to-market securities owned by banks are all shorted or sold down, regardless whether the rumours are true or not. Even though the banks were initially well-capitalised, the sudden wipe-out of trillions dollars of market value caused these banks to be almost bankrupt overnight.

And guess what? In Singapore, you do not even need to borrow shares to short! The exchange here instead encourage naked short selling by saying that you do not even need to borrow shares to short because they have "rules" to deter them! Like real!

That is why so many hedge funds are based here. They can short to their hearts content. Now you know why the companies listed in our exchanges are so cheap compared to other countries' exchanges?

Like I mentioned in the previous post, if the exchanges around the world still support naked short selling, more and more companies will be either taken private by the own management, or bought over by private equities and taken private. You will also find that all those well-run businesses will shun IPO.

In fact, I'm advising others to go for venture capitalists instead of IPO. It's not worth it because the exchange is not interested in ensuring a fair value for your company. The private investor will value your company better than the exchange.

I hope this incident will trigger some new rules at least, as this fundamentally goes against the concept of the public exchange and shareholders. Just imagine you're selling lemonade, and someone else claims that he/she is selling your leomade and sells it cheaper than you, without actually having the actual lemonade itself.

It totally makes no sense...