Understanding the Stock Trade Process

Imagine Grandma on the left has savings, and the fellow on the right has some stock. Grandma wants to buy the stock with her savings. In most countries, the money and stock change hands within a few days after the trade, known as the settlement period (T+2 or T+3).

However, in the U.S., the mechanisms for exchanging money and stock have become disconnected. While the system operates on a T+3 settlement, it’s possible for the money to settle whether or not the stock settles. This is where the concept of Failure to Deliver (FTD) comes into play.

The Role of the DTCC

The Depository Trust and Clearing Corporation (DTCC) acts as a central back office for Wall Street, where trades settle three days after the trade date. In reality, settlement often occurs within the DTCC, as brokerage houses have accounts at the DTCC and transfer money and stocks between their customer accounts.

The Loophole: Failure to Deliver (FTD)

Let’s consider a scenario where there’s a delay in settling the trade. Suppose Grandma’s money settles through the system, but the fellow on the right can’t settle his shares for a legitimate reason, such as a paper stock being stuck in a bank vault. The system creates an IOU for the stock, which is treated as normal stock by the broader system.

However, this creates a loophole that can be exploited by a “miscreant” or someone who wants to game the system. The miscreant can perform a trade with Grandma, create an IOU for the stock, and then repeatedly do this without actually having the stock to deliver. These strategically created IOUs are known as Failure to Deliver (FTDs).

The Impact of FTDs

The FTDs flow through the DTCC and bounce around within the system. If the number of FTDs becomes significant compared to the legitimate shares, it can start to affect the supply and demand dynamics of the stock, causing the price to collapse.

The miscreant’s actions of creating FTDs can shift the supply curve to the right, leading to a dramatic drop in the stock price. This can have devastating consequences for the company, as it becomes a penny stock, making it difficult for the company to access capital markets and continue its operations.

Broader Societal Implications

The impact of this kind of attack can be far-reaching, not just for the company itself, but for society as a whole. Shareholder value is wiped out, jobs are lost, and potentially promising technologies and products are never brought to market.

The Scariest Scenario: Naked Shorting

The scariest scenario is when the miscreant’s shorting is not just traditional shorting, but “naked shorting,” where they create FTDs without even borrowing the underlying stock. This can lead to a situation where there are more FTDs in the system than there is real stock to be bought, causing a complete market dislocation and volatility.

The revised version of this blog post aims to provide a more comprehensive and engaging explanation of the Failure to Deliver (FTD) problem and its potential impact on the stock market and the broader economy. By adding more details and examples, the post helps readers better understand the gravity of the issue and its societal implications.