Photo by erix!

Photo by erix!

Retail brokerage customers generally never learn that they paid money for something that failed to be delivered to their accounts. That is because retail customers’ brokerage account statements do not reveal whether delivery takes place; even when no shares are delivered at settlement, share entitlements are still credited to the buyer’s account. Those credited share entitlements then trade in the market as if they were real shares issued by the company. – WorldAffairsJournal Regulation (Spring 2008)

Huh? What’s the above about? It’s about the practice of selling shares without owning any shares, also called “Naked Shorting” and then failing to deliver the shares. In the US market, they use the term “Failure to Deliver” to describe it. The consequence of this act is to increase the number of outstanding shares of a company and basic economics of demand and supply states that when the supply increases, price goes down.

So, let’s say Company A issued 1000 shares. Anyone who owns 1000 of these shares own 100% of company. Let’s say a hedge fund “naked short” another 1000 shares and “fails to deliver” it. These 1000 “naked short” shares are credited as electronic digits into the buyer’s online brokerage account and are paid for by the buyer. The total number of shares appearing as electronic digits are now 2000 shares, but the number of shares legally issued is only 1000…so what now? The buyer has effectively paid for nothing! It has been said that such practices resulted in many good fundamentally strong companies being driven to bankruptcy in the US and it is claimed that this is rampant in that country. It is also conservatively claimed that about 1% of daily shares volume traded in the US market are such ” phantom shares”.

Guess SGX did a fine job to mandate that investors buy back any naked shorted shares in the market within 1 day or else face a fine of $1000.

Read the articles below for more information. Hmm…we wonder how will the companies issue dividends in this case? Read more…