We all know Wall Street makes Billions of dollars every year with Investment Banking, Sales & Trading, and the Financial Quants taking most of the credit. But there’s another less prominent area within the top Investment Banks that quietly makes a lot of money.
A LOT OF MONEY!
This area was recently exposed in a potential $1Trillion class action lawsuit, which reveals a secret held by one of the tightest groups of traders on Wall Street.
This video takes you into those dark, shadowy corners of the top Investment Banks and explains how this Boys’ Club makes their money, who loses it, and the current fight to get it back. You’ll also meet the man who helped uncover it all, his reason why, and the company he’s leading to change the game.
In fact, this story is so unbelievable – even Mickey Mouse makes an appearance.
Wall Street’s Best “Unknown” Business
“This is a field that’s been notoriously murky and fuzzy, and lots of complaints [that] the SEC has tried to clean up.”
– CEO, Company Earnings Conference Call, August 3rd, 2017
Investment Banking and Sales & Trading get most of the attention on Wall Street. They are the high-profile areas of the Investment Bank that bring in the Revenues – or “The Front Office.” But you generally don’t hear much about Prime Brokerage, a unit that facilitates the trading operations of Hedge Funds. As it turns out, there’s a group within Prime Brokerage that’s a significant revenue source for the Investment Bank. So, let’s dig a little deeper.
What is a Prime Brokerage’s core service?
Prime brokers provide a wide variety of financial services to their hedge fund clients, including acting as an intermediary between them and two key counterparties: large institutional investors, such as Pension Funds; and, Commercial Banks. These two counterparties, with the aid of this group within Prime Brokerage, provide a KEY service: to enable Hedge Funds to engage in large-scale Short Selling through borrowing stocks from the Pension Funds; and, obtaining financing from Commercial Banks. That group is called the Stock Loan desk – and it’s the target of a potential $Trillion class action lawsuit.
What is “Short Selling”?
Short selling is a common trading strategy most often used by hedge funds. It’s the sale of a security that is not owned by the hedge fund. In order to physically sell the security, they have to borrow it. You can think about short selling as the exact opposite of buying a stock because you think it can go up, and then selling it to lock in a profit. Short selling allows you to sell a stock because you think it will go down, where you will buy it back for a profit.
How does the Short Selling process work?
Prime brokers reach into the supply of Pension Fund holdings to locate stock and meet the demand of Hedge Funds looking to short that stock. The Hedge Funds pay the Prime Broker a fee to borrow the stock. Given the finite number of shares outstanding, greater demand for a locate on a stock raises the price that Hedge Funds need to pay to “Borrow” that one share. Without finding a locate through the Prime Broker, Hedge Funds are prohibited from shorting the stock. Doing so is called “Naked” Short Selling.
In January 2005, the SEC implemented Regulation SHO (REG SHO), specifically to curb “Naked” short selling. However, with regulators seemingly turning a blind eye and not much deterring Prime Brokers from lending out more shares, it’s been revealed that the practice of offering “locates” to more borrowers than shares available became rampant.
One CEO of a company attacked by Naked Short Sellers had this to say:
“The SEC was scolding publicly a couple of the large prime brokers saying – in front of the crowd saying: we do these audits of your locates and we get into your books and records and where you (were) supposed to have recorded whose stock it was you gave a locate to … you’ve recorded Mickey Mouse or 3 dots.”
– CEO, Company Earnings Conference Call, August 3rd, 2017
In essence, Prime Brokers were making multiple times the borrow fee on shares they didn’t have to lend. This practice seemingly paid off handsomely, as it’s now estimated that as much as 75% of a top Prime Brokerage’s (Goldman Sachs) revenues come from Stock Lending. And to give you some context, according to data-analytics company Coalition, Prime Brokerage is about 35% of Wall Street’s Equities Division.
For every winner, there’s a loser
“Well, I think this could become the first $1 trillion lawsuit in American history.”
– CEO, Company Earnings Conference Call, November 8th, 2017
Now, these Prime Brokers have a cost – they need to pay the Pension Funds for the use of their stock holdings. And these Pension Funds would want to get paid. They’re currently in a crisis where some are fighting potential bankruptcy. According to Bloomberg, the median funding ratio – or the ratio of assets States have available for future payments to retirees is almost 70% – that’s a 30% shortfall!
So yes, the Pension Funds want (and deserve) a piece of the revenue generated from the stocks they are holding. They agree to a cut – Generally, it’s 30%. 30% of what the Prime Broker makes from lending out the stock. If the Prime Broker is lending the stock for $20 then the Pension Fund makes $6. Not bad.
Except…
Here’s where it gets more interesting. Enter Prime Broker 2. What happens if Prime Broker 1 borrows from the Pension Fund and then lends it to Prime Broker 2? Not at $20; but AT $2?!? How much does the Pension Fund receive now? Yes, $0.60. 30% of $2.
Now, instead of Prime Broker 1 lending it to the Hedge Fund, Prime Broker 2 lends it at the same $20, netting $18. The Hedge Fund pays $20, the Pension Fund makes $0.60, and two Prime Brokerages make the difference, $19.40.
“And then there are various kickback mechanisms that allow… like overnight repo trade … that allows one prime broker to kick back their fair share to the other prime broker.”
– CEO, Company Earnings Conference Call, August 3rd, 2017
This scheme is much easier to perpetrate because the stock lending market is not traded through an exchange – pricing isn’t transparent. If it were, then the Pension Funds would be able to see that the Hedge Funds are paying $20 and demand their fair share.
It’s quite amazing that this market lacks pricing transparency with $1.72 Trillion of shares on loan at any one time. That’s a Trillion with a “T.” Fair markets need transparency and regulation.
We learned who wins (the Prime Brokerages), but who loses?
Teachers, nurses, firemen, and police officers.
The Pension Funds lose. But they’re fighting back!
In August 2017, a class action lawsuit was filed by 3 pension funds against 6 top Prime Brokerages: Bank of America, Credit Suisse Group, Goldman Sachs, JP Morgan, Morgan Stanley, and UBS Group.
The allegation: Collusion.
“Collusion among six of the world’s largest investment banks to prevent modernisation of the securities lending market.”
– Andrew Neil, Lawsuit puts Spotlight on Securities Lending Market, globalinvestorgroup.com, September 12, 2017
A potential $1Trillion lawsuit.
How was this all revealed? What caused it?
The Company and its CEO
“(This Company’s) blockchain does exactly what blockchains do best – stop people from cheating.”
– Jacob Dienelt, (Company name) Blockchain and the War Against Naked Shorting, Coindesk.com, November 9th, 2016
In 2004, this stock was flying high. However, by 2005, the “Shorts” started taking a stand as they believed the competition in the industry would overwhelm this company. Over the next 5 years the Shorts, in particular, the alleged “Naked” Shorts, and the CEO of this company were waging a public war. One side screaming “Cheater!” and the other “Crazy!”
The company was Overstock (NASDAQ:OSTK). It’s CEO, Patrick Byrne.
As the CEO, he is the ultimate defender of his company. During those 5 years, OSTK appeared on the REG SHO list for 3 of them, which designated that Short Sellers were failing to deliver the stock. Besides thoughts of potential fraud against his company, to him, it was a sign of a much bigger problem. And he wasn’t going to play the role of a silent bystander.
He fought back targeting those Short-Sellers failing to deliver, prime brokers, and the SEC. The harder he attacked, the greater the backlash from all angles. Here’s Herb Greenberg, a famous Short-Seller going after him:
“But that’s not the point of Byrne’s post: No, in the wake of the market’s mini-meltdown last week, he explains that it was he, Patrick Byrne, who was trying to warn regulators that “we were standing at the edge of an economic crisis perhaps comparable to the 1929 market collapse, due primarily to the SEC having become a ‘captured regulator’ which turned a blind eye to the fraud it was created to suppress.” He wisely doesn’t use the term “naked short-selling.” Instead, in an apparent attempt to capitalize on the market’s turmoil, he refers to “latent derivative risk (in the form of unsettled trades in our settlement system) among a vast network of hedge funds and their prime brokers.”
– Herb Greenberg, Overstock.com: Patrick Byrne’s Private War Against Naked Short-Sellers, Seeking Alpha August 13th, 2007
Prescient comments by Patrick Byrnes to say the least. Remind you – this is August 2007, months before the greatest collapse since – Oh, 1929! And, Mr. Greenberg was correct to point out that Patrick didn’t use the term “Naked Short Selling,” probably because he had already figured out the scheme outlined earlier. It’s not “Naked” (by the Hedge Fund) if the Prime Broker gives you a locate – even if that locate comes from Mickey Mouse!
Finally, Greenberg seemingly laughs at the notion that “unsettled trades” would ever become a problem. Until they did during the 2009 crisis. The former Chairman of the Federal Reserve, in front of Congress, even pleaded regulators to make changes:
“There are additional regulatory changes that this breakdown of the central pillar of competitive markets requires in order to return to stability, particularly in the areas of fraud, settlement and securitization.”
– Dr. Alan Greenspan, Congressional Hearing, October 23rd, 2008
When you seemingly can’t win the battle. When your protectors don’t seem to take you seriously. Most people back down. There are a few people, knowing truth is on their side, that maintain the commitment to keep fighting and the resolve to win the war by creating a better solution. Patrick Byrnes defines the latter.
In 2014, Overstock created Medici Ventures. Medici is a wholly-owned subsidiary of
Overstock that invests in blockchain technology. One investment is an 80% stake in tZERO.
It’s this stake (tZERO) that potentially holds the solution to transparency in the lending market, better economics for the end parties involved, and a diminished role of the middleman – the Prime Broker.
The Solution
“What we have invented is a thing that can basically re-plumb this piping and have it go back to the pension funds, thereby, lessening the pension fund crisis.”
– Patrick Byrne, Overstock Q3 Earnings Conference Call, November 8th, 2017
tZERO created a system where buyer and seller of the “borrow” can transact at an efficient market price.
How?
Each night through an auction process, borrowers (Hedge Funds) and lenders (Pension Funds) determine the borrow price. The borrower pays the market price and receives a digital locate receipt (a DLR) which is a digitalized version of a REG SHO locate. This DLR, through blockchain technology, keeps an audit trail all the way back to the actual stock certificate in an account at the DTCC. So, your counterparty is the DTCC.
Under tZERO’s solution, Pension Funds receive 80% of the borrow price established by the auction while tZERO gets 20%. Due to transparency and no middlemen mark-ups, the price of the borrow most likely declines. In our example, suppose the borrow price is now $10 instead of $20. Now, the Pension Funds get $8 and tZERO receives $2 – A much different outcome then what we saw earlier. Here, the greater % of the loan revenues go to the party that is lending the stock.
In August 2017 Patrick Byrne stated:
“It’s a great solution to this and [the] biggest business opportunity we have ever looked at… We think this is a revolutionary product.“
– Patrick Byrne CEO Overstock, Overstock Q2 Earnings Conference Call, August 3rd, 2017
The Blockchain technology used by tZERO has created a solution that is simple, transparent, accountable, and more profitable for the party who needs it most – the Pension Funds.
Just the Beginning (or the End?)
“These days, when people talk of Byrne, the word ‘vindication’ comes up a lot. But, Byrne wants more than vindication – he wants to win.”
– Jacob Dienelt, November 9th, 2016, Overstock’s blockchain and the war against Naked Shorting, Coindesk
Overstock had a remarkable 2017. After a decade of being left behind, the stock is up over 400% since their August earnings report where Patrick Byrne highlighted the tZERO story. Since that time, the stock has attracted large institutional players like George Soros and John Burbank. Even one of the most outspoken critics of Patrick Byrne who had been short Overstock, Marc Cohodes, reversed course and now owns the stock.
And early numbers show that tZERO has gained some traction in the stock lending market. According to Overstock CEO Patrick Byrne…
“It’s got well, each day for the last 5 days, $80 billion to $120 billion of securities to lend, including lots of hard-to-borrow… who knows if this gets off the ground or if the whole industry collapses into our lap like a thunder clap. I don’t know, but you now know everything I know, you really do.”
– Patrick Byrne, Overstock Q3 Earnings Conference Call, November 8th, 2017
The shorts may have won the battle … but will Patrick Byrne win the war? Only time will tell.
A significant portion of the information shown on this video can be found on the Second Quarter and Third Quarter Overstock Conference Call transcripts, spoken by the CEO of Overstock, Patrick Byrne. You can access these transcripts at www.overstock.com under Investor Relations/Events & Presentations.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.