How hedge funds and brokers have manipulated the market
by Lucy Komisar
Part 4 - The Big Scam
In 2007, online retailer Overstock sued the major prime brokers for naked shorting its stock and creating counterfeit shares that flooded the market, causing its share price to drop from $70 to $20. It presented evidence that Goldman Sachs created fake inventory for stock lending.
Here’s how an insider described it in a 2011 Overstock court deposition: “A firm or a market maker would synthetically create a short position by doing option trades in it, buying the stock, selling a call or buying a put or this, that and the other. And by buying the stock, they could create a borrow off an option trade.”
In the conversion trade, an options market maker is on one side, and a prime broker on the other. It isn’t real market making, which is to be in the middle so all traders can buy or sell shares, or in this case, options. “The goal of the trade is to get the prime broker loanable inventory of stock,” Welborn said.
How do you get there? You get there by this conversion trick. First, the options market maker sells the prime broker a naked short that never settles from the market maker. This is “the most important leg of the trade,” Welborn explained. The market maker also sells a put option (an option to buy the stock in the future) to the broker. This gives the market maker a neutral position, but the broker can maintain a “long” position, as if they owned the stock.
In the conversion trade, an options market maker is on one side, and a prime broker on the other. It isn’t real market making, which is to be in the middle so all traders can buy or sell shares, or in this case, options. “The goal of the trade is to get the prime broker loanable inventory of stock,” Welborn said.
How do you get there? You get there by this conversion trick. First, the options market maker sells the prime broker a naked short that never settles from the market maker. This is “the most important leg of the trade,” Welborn explained. The market maker also sells a put option (an option to buy the stock in the future) to the broker. This gives the market maker a neutral position, but the broker can maintain a “long” position, as if they owned the stock.
The broker can now lend that stock out to multiple clients. In this way, the prime broker and the market maker are creating fake lendable shares out of thin air. The end result is organized counterfeiting of shares in the market.
Regulators aren’t providing enough transparency to ferret it out. As Welborn said, “Regulators tell us there are fails but don’t tell us who did the fails. Liquor stores are being robbed, but they don’t tell us who robbed the stores.”
There is voluminous evidence from the Overstock case of Goldman Sachs engaging in this practice, including an email from a broker conceding that such conversion trades “create inventory to allow customers to short.” When Overstock got the incriminating evidence, after Goldman’s lawyer posted it by mistake on PACER, the federal court online filing system, Goldman settled with Overstock in 2015 for $20 million.
Regulators aren’t providing enough transparency to ferret it out. As Welborn said, “Regulators tell us there are fails but don’t tell us who did the fails. Liquor stores are being robbed, but they don’t tell us who robbed the stores.”
There is voluminous evidence from the Overstock case of Goldman Sachs engaging in this practice, including an email from a broker conceding that such conversion trades “create inventory to allow customers to short.” When Overstock got the incriminating evidence, after Goldman’s lawyer posted it by mistake on PACER, the federal court online filing system, Goldman settled with Overstock in 2015 for $20 million.
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