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Introduction

A week and a half ago, Tesla announced a five-for-one stock split, and the stock has been on an absolute tear since then:

Yahoo - TSLA Chart - 3/8 to 22/8

Ever since then, there have been discussions on the TMC Investor Forum about how various parties are affected by the stock split. What happens to long positions, derivative positions, and normal short positions is relatively straight forward, and it didn't take long for the consensus to reflect this. However, a consensus has still not been reached on how one particular position is affected by the stock split: a naked short position.

I've done quite a bit of research on the inner workings of the stock market since then, and I believe I can shed a lot of light on precisely how naked shorts work, so that people can have a more informed opinion on the subject. I will present all of this research in this short blog post.

The inner workings of the stock market

Although the girl's Indian accent is rather hard to understand, this is the best explanation I've found of what happens after a stock trade between two parties is agreed upon:


The following picture pretty much sums it up:


It works very similar from the buyer's and seller's side. Here is how it works from the buyer's perspective:
  1. A trade is agreed upon on day 0.
  2. Money is instantly deducted from the buyer's account, and goes into his broker's account so that it can execute the trade for its client.
  3. The broker has to make a margin deposit with the exchange's clearing corporation, which is the middleman and guarantor of the trade. More details on this below.
  4. On day 1, the broker moves the funds into a dedicated bank account from which the payment will be sent to the seller's bank account.
  5. On day 2, settlement takes place. The funds are sent to the seller's broker's bank account, and the buyer's broker receives the assets purchased in its depository. Depositories are central entities where assets are held. You can think of them like a bank for stocks/options/etc.
  6. The broker will transfer the stock received to the buyer's (segregated) account.
Now, to understand how naked short selling works in detail, the most important thing is to understand exactly what the clearing house does. This video explains it in detail:


Essentially, when a trade is agreed upon, the clearing house becomes the opposite party of both the buyer and seller. Instead of having to deal with each other, the buyer and seller will deal with a central, trusted organisation acting as a guarantor. To do so, the clearing corporation requires a margin deposit from both parties when a trade is agreed upon.

So in essence, a broker is usually the middleman between the buyer/seller and the market. And a clearing corporation is the middleman between the buying broker and selling broker.

How a naked short sale works

Naked short sales are a bit different and more complicated, but fortunately I've stumbled upon this research paper on the SEC's website, which gives a detailed explanation of how naked shorting works behind the scenes:


Short sales are usually accomplished through equity loans. The short-seller borrows shares from an equity lender which he delivers to the buyer. This debt of shares to the lender gives him short exposure going forward. But there is another way to create the same exposure: by failing to deliver the shares. If the short-seller delivers nothing to the buyer, thereby incurring a debt of shares to the buyer, this also gives him short exposure going forward. This alternative moves the risk that the short-seller does not repay his debt from the equity lender to the buyer, but just as equity lenders have a mechanism for ensuring performance, i.e. collateral, so does the buyer. The clearing corporation intermediating the trade takes margin and marks it to market, thereby defending buyers against their sellers’ non-performance. If equity loans are expensive, unavailable, or unreliable, as research shows they can be (e.g. D’Avolio, 2002, Geczy, Musto and Reed, 2002, Jones and Lamont, 2002, Lamont 2004) then this alternative appears desirable, to short sellers if not to buyers. But considering the market rules that bind short sales to equity loans, how is it feasible? 

The answer, we show, lies in the special access to delivery fails that option market-makers enjoy. Traders are generally obliged to locate shares to borrow before shorting, but those engaged in bona-fide hedging of market-making activity are exempt from this requirement. So unlike traders in general, a market maker can short sell without having located shares to borrow. If he does not locate shares to borrow then he fails to deliver, someone on the other side fails to receive, and therefore retains the purchase price, and the clearing corporation starts taking margin. While it lasts, this arrangement is effectively an equity loan from the buyer to the seller at a zero rebate. But whether it lasts depends on the reaction of the trader being failed to. If a buyer does not get his shares then he can demand them, in which case a short-seller who failed is bought in: he must go buy the shares and hand them over. If that short-seller wants to maintain his short exposure he must short again, so this demand increases his shorting cost by this roundtrip transactions cost. Thus, the cost of failing to deliver is the cost of a zero-rebate equity loan plus the expected incidence of buy-in costs. If this incidence is low enough, then failing is a valuable alternative to borrowing the harder-to-borrow stocks. We show that the alternative to fail is valuable and key to the pricing and trading of options.  


So in essence, market makers can simply not deliver shares to the buying broker after 2 days. At this point it effectively becomes the same as the debt between a long who lent out his shares and the borrower of those shares. The buying broker can 'demand' this debt at any time, forcing the naked short-seller to buy the shares and hand them over.

How the split could be squeezing the naked shorts

A few TMC forum members, most notably Artful Dodger* and StealthP3D, have been arguing that a TSLA stock split would somehow screw over the naked shorts, and force them to cover. Although I initially thought this was likely true, as I began to research more about depositories and clearing agencies, I became very outspoken against this idea.

*Credit for first bringing naked shorting to the TMC community's attention goes to Artful Dodger

For one, I argued that nobody other than Tesla can create shares out of thin air. And even if some entity could, then why wouldn't they just create more? Most likely, I thought that the debts of naked shorts to buyers would simply be adjusted after the split, just like the debts between regular shorts and stock lenders. A regular short's debt to a stock lender will stay the same in dollar value, but the number of shares will multiply by 5 while the stock price is divided by 5. Just like every long position. While I still think this could be true, and that every outstanding equity debt between brokers and the clearing corporation could simply be adjusted post-split, I do now see a plausible theory that'd mean the naked shorts are currently being squeezed by the split.

Normally, the maximum amount of time between a trade and settlement is 3 days, so normally the maximum amount of time an equity debt between a broker and the clearing corporation exists is 3 days. However, in the case of naked shorts these debts can stay around for much longer until the buying broker demands the shares. If, when the stock splits, only equity debts from a certain date onward get adjusted from 1 share to 5 shares, that could mean that old equity debts of naked short market makers will not be adjusted post-split.

Of course the naked short market-makers are pretty ecstatic if this happens, because each share they owe post-split will be 80% cheaper, but the other side of the trade, the buying broker, is of course not so happy, because it'll now only be owed 1 share for each 5 shares it owes its clients. Therefore, if this is true, buying brokers would be demanding that all these equity debts be covered right now before the split, leading to a (naked) short squeeze.

Looking at the stock price action over the last week and a half, one might be quick to conclude a naked short squeeze is indeed in progress, but I'd like to point out that delta hedging requirements have gone up immensely since the stock split announcement:


This table shows that market makers would have had to buy 30M shares over the past 8 trading days, if they are short 100% of options open interested, and if they delta hedge 100%. Probably neither of those are true, so the real number is likely lower, but nonetheless market makers were forced to buy a very large number of shares over the past week and a half, which undoubtedly contributed significantly to the TSLA rally.

Conclusion

Although I don't think anybody but a handful of parties can conclusively say whether a naked short squeeze is or is not in progress, there is a possibility that it's contributed to the 50% rally over the past 8 trading days.

Considering that S&P 500 inclusion is still ahead of us, and that the buying of 26M+ shares by funds indexed and benchmarked to the S&P 500 will likely be a very different beast than any sort of naked short covering that may or may not be going on right now, I think more interesting times lie ahead for TSLA investors.

It continues to amaze me how many 'professionals' neither understand Tesla nor TSLA. Even the few professionals who have a decent understanding of the company's potential seem to be baffled by the stock movements, and simply don't seem to understand:

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