 |
| Photo by Spencer Tunick, Netherlands 8 (Dream Amsterdam Foundation) 2007 [link] |
If short sellers are considered to be the Mussolinis of the financial market, then naked short sellers are its Hitlers.
In this post I'll show that naked short selling isn't solely a hedge fund or equity market phenomenon. In fact, the good old fashioned practice of deposit banking amounts to what is essentially naked short selling, thus making staid bankers, and not hedge funds, the world's largest naked short sellers. This means that anyone who vilifies the naked short selling of equities must also be against the common practice of banking—a crack pot position if there ever was one.
Short selling is when an investor borrows shares of, say, Microsoft, then sells those shares in the open market. At some point—either at the lender's behest or the investor's—the borrower will repurchase the shares in the open market and return them to the lender. A short seller hopes that the price of Microsoft has declined in the interim so that when the time comes to repurchase them, it will cost less money, thus resulting in a profit to the short seller.
Naked short selling is similar in every respect save for one: when our investor sells Microsoft shares short in the open market, they do so without borrowing those shares ahead of time. (To get more specific, read this SEC page)
Which sounds odd, right? How can someone sell something if they haven't either purchased it or borrowed it ahead of time? No wonder people wrinkle there noses at the practice of naked shorting—it seem like sleight of hand!
The best way to think about naked short selling is to turn to banking. Why? Because bankers engage in short selling every.single.day. Just as an equity short seller will borrow and then sell Microsoft with the intention of repurchasing it at a better price, bankers borrow and then sell dollars with the intention of repurchasing them at a better price. Apart from the respective instruments involved, dollars vs stock, there's no difference between what an equity short seller and banker are doing.
So if bankers engage in short selling, do they act as mere regular shorts sellers or do they get naked?
In the previous paragraph you may have noticed that I described banking as the borrowing of depositors' dollars in order to lend those dollars out. Because the dollars were borrowed prior to sale, this would qualify their activity as regular short selling, not naked short selling.
But hold on, this isn't at all how banks function. Bankers don't wait for physical Federal Reserve dollars to be deposited by the public before selling them away—they short dollars whenever they wish, creating electronic deposits out of nothing in order to buy things like bonds or personal IOUs. Banks are engaged in naked shorting pure and simple: they sell a financial instrument that they never actually had in their possession.
How do they do this? The key here is that banks don't actually sell Fed paper dollars short, rather, they sell dollar-linked IOUs (i.e. deposits) short. A deposit is a claim on the bank's capital that mimics Fed paper dollars by being indexed, or denominated, in terms of those paper dollars. It's similar to a Fed dollar, but it's an entirely different instrument.
Circling back to naked equity short sellers, the same thing is occurring when a naked short is initiated. The instrument that they are selling short isn't a Microsoft share, but a newly-created IOU that is denominated in Microsoft shares. It would be as if I gave you scrap of paper with the words "I owe you one Microsoft share" on it. Rather than buy a real share, you could just hold the IOU I gave you. The instrument would look like a share, walk like a share, and even circulate alongside shares, however it would be an entirely new financial instrument.
This ability to "print" new IOUs denominated in terms of Federal Reserve dollars (in the case of the banker) or in terms of Microsoft shares (in the case of the short seller) often results in a quantity of derivative units that far exceeds the underlying issue of base units. We get an inverted triangle of sorts where on top of a narrow base of Fed paper dollars is arrayed a much larger quantity of dollar-denominated deposits, often 10 or 20 times more. Likewise, the number of Microsoft-denominated IOUs that naked short sellers create may eclipse the number of actual Microsoft shares outstanding.
It is the naked short seller's possession of a so-called printing press that draws the wrath of CEOs. The accusation is that a hedge fund can make a good profit by manufacturing and selling massive quantities of Microsoft-denominated IOUS in order to drive Microsoft's stock price down to zero, thus benefiting its short position. Emblematic of this belief is the battle waged by Overstock CEO Patrick Byrne against short sellers who had been engaging in naked selling of his firm's stock, which had fallen on hard times. As early as 2005, Byrne accused short sellers of creating a fake supply of Overstock shares (at one point reputably six times more than actual shares issued) in order to drive its price lower. Byrne went so far as to launch several lawsuits against the perpetrators.
How legitimate is Byrne's concern? Let's return to our bank analogy. Is there anyone who would argue that because banks can create and short deposits willy nilly, they'll drive down the underlying Fed dollar's price towards zero (ie. create hyperinflation) and thus earn outsized profits? Of course not. Banks in the U.S. and Canada have been creating deposits for centuries without causing hyperinflation. It simply isn't a concern because the issuer of underlying dollars, the Federal Reserve, stands ready to support the value of the dollars it has issued. It can provide this sort of anchor because it holds a variety of assets that can be mobilized to repurchase and cancel paper dollars, thereby removing any excess supply that might emerge thanks to competing issues of dollars by banks.
Likewise, if naked short selling creates a glut of Overstock IOUs and begins to drive down the price of Overstock, then in the same way that the Fed can deploy its assets to remove the supply of Fed dollars to stabilize their value, Overstock's Patrick Byrne could have used his firm's assets to repurchase stock. If he chose not too do a buy back, one might wonder if his company had the assets on hand to begin with.
To sum up, in the same way that bank issuance of dollar-denominate IOUs cannot drive the purchasing power of underlying Fed dollars down as long as the Fed has sufficient assets and chooses to use them, neither can naked short sellers drive Overstock prices down if the company has sufficient assets and is willing to conduct the necessary repurchases.
So haters of naked short selling, are you consistent in calling for an outright bank on banking? You say that naked shorting drives down stock prices, which means you no doubt also believe that banks inevitably create hyperinflation, right?
Addendum:
JKH has a post on the topic here, the Full Monty on Naked Short Selling.
Interesting new take on banking JP.
ReplyDeleteBut if the Bank of Canada (like most corporations) owned very illiquid assets, that couldn't be sold quickly, then commercial banks would cause inflation.
It would not apply to 100% reserve banks.
I don't see the economic difference between short selling and naked short selling (and I fear to read the SEC page). If I borrow a Microsoft share, I give the lender an IOU. That IOU promises to pay Microsoft dividends, and promises to pay one Microsoft share on demand. That IOU is a synthetic Microsoft share.
"...that couldn't be sold quickly, then commercial banks would cause inflation."
DeleteI can get behind that. One thing that would prevent inflation or a collapse in a stock price would be if a third party came in and accepted those illiquid assets as collateral for a liquid line of credit, with which the central bank or the company could repurchase the liabilities it has issued.
"I don't see the economic difference between short selling and naked short selling."
It's true that both short selling and naked shorting created a synthetic Microsoft share. My feeling is that a short seller can create more synthetic shares by going naked. They don't have to wait for a 'deposit' of client shares, they can initiate the transaction on their own.
For instance, you can only short a stock if your broker can borrow that stock, and that requires that someone hold that stock in a margin account. Stock that is held in a regular cash account, or a non-taxable account, can't be lent out. However, if you can go naked, you needn't wait for a stock to appear in someone's margin account--you can just go out and create it. It seems like the ability to go naked would reduce the costs of creating IOUs, but I could be wrong.
DeleteCertainly there's a cost involved. If you have borrowed stock to cover a short sale, you'll be paying stock lending fees and have an opportunity cost on the use of collateral.
DeleteExcellent points, and very much neglected in the Finance texts.
ReplyDeleteHere's another way to take a naked short: A and B make a bet. For every dollar that GM rises, A pays B $1. For every dollar that GM falls, B pays A $1. A just went short in GM and B just went long. This makes it pretty easy to get around laws against short sales, especially if those bets are made outside of US borders.
Neat. Sounds like a swap.
DeleteBut that scenario doesn't get into the equity creation described in the post. Byrne's argument is a bit of a distraction given the deep pockets of the market, and the tendency of market participants to be stingy with excess returns. However, increases in naked short float redistributes market value away from the existing investors. What if the shorts liquidate and fail to deliver? Cash streams from new investors to the shorts, leaving old investors with reduced ownership, unless they pony up in the secondary market. In that view, anticipation of third party dilution might be cause for higher return requirements.
DeleteI also didn't understand the point about repurchasing stock as a response to naked shorting. Doesn't that weaken your argument about the neutrality of naked shorting? If a company is induced to payout funds that would have otherwise been reinvested, that seems to assume a real impact, in which the market value of the company has actually depreciated in response to the shorting. Otherwise, if market value is simply redistributed, why would the payout policy change? It should simply scoop up more shares, but according to the same dollar cost.
Companies might avoid buybacks, and dividends, for reasons other than poor asset quality, even assuming large valuation mismatches. Time sensitivity, first mover competition, deleveraging, and other investment needs might claim funds. Stock valuations will usually incorporate these scenarios, which raises an interesting question about CEO's fiduciary responsibility. If the stock valuation falls to such an extent that existing shareholders benefit if you discard important long-term investment in favor of a payout, should the CEO thus act for the benefit of the current shareholder base? If yes, then scenarios in which naked shorting actually succeeds in reducing market value to such a point also assume the capability of impairing corporate investment.
Delete"If a company is induced to payout funds that would have otherwise been reinvested, that seems to assume a real impact, in which the market value of the company has actually depreciated in response to the shorting."
DeleteIf short sellers drive a firm's value below fundamental value, the firm can earn a profit by buying and retiring those shares. The stock doesn't have to fall very far below fundamental value before the return from stock repurchases exceeds that of any other investment. Those repurchases will eventually drive the share price back to fundamental value, at which point the list of other investments becomes more persuasive relative to share buybacks, at which point the company will continue on its regular path of making real investments.
Put differently, as a shareholder of Company x, I'd be pleased to see naked short sellers drive the share price of x below fundamental value as that would give x's management the opportunity to make profitable repurchases of shares, thus increasing EPS for existing shareholders. On net, I'm better off.
I'm not sure that it's helpful to phrase that scenario as "the firm profits". After all, post-buyback, the firm has fewer investable assets. The company is the issuer of stock, so it isn't economically purchasing and selling its shares like an investor. The economic beneficiaries are the shareholders who made the decision to retain their higher ownership %. That's the same dynamic as you see with a dividend. Buybacks are just payouts. The onus for reinvestment (increasing ownership) is upon the shareholders.
DeleteSo one challenge to naked shorting neutrality is whether it is socially optimal to allow third party share creation that might induce real changes in corporate investment.
Post buy-back, the firm will have sold assets in order to buyback shares (or maybe not, it could have got a loan), but the number of assets in the economy will stay the same. Some other firm had to buy the asset, after all. It doesn't go up in smoke.
DeleteA:
Delete"However, increases in naked short float redistributes market value away from the existing investors."
If I understand that correctly, it's an age-old fallacy. The shorting is nothing but a side bet on the market, and does not affect the assets or liabilities of the underlying firm, or its ability to raise investment capital. For the same reason, the existence of call and put options does not affect the underlying firm.
"The shorting is nothing but a side bet on the market, and does not affect the assets or liabilities of the underlying firm, or its ability to raise investment capital."
DeleteSay you and I make a $50 billion side bet. It affects nothing but the two of us.
Say you spend $50 billion driving up the price of the stock, or by selling short you spend $50 billion driving down the price of the stock. You are affecting lots of things besides just you and me. I don't know whether it affects the underlying firm to have the stock go way down all of a sudden or not. Probably sometimes yes, sometimes no.
If you successfully drive the price down and then get a lot of scared investors to sell to you at a loss, you've definitely affected them, you've taken their money. If they had the faith to buy low then they would limit your ability to drive the price down and they would share in your wealth, buying cheap and later when you were done selling high.
I don't see that these shenanigans have any value to society apart from the opportunity for well-capitalized gamblers to prey on more-conservative or less-informed investors.
J Thomas:
DeleteSuppose that GM's only asset is a bank account with $60 mil in it, and the only thing on the liability side of GM's balance sheet is 1 million shares of stock. Each share will be worth $60. If I short a lot of GM shares, and if I thereby drive GM down to $59, I'm just putting myself on the wrong end of an arbitrage process, and I'd go broke.
The social value of shorting is that it allows more opinions to be brought to bear on the value of a stock, and thereby prices the stock more efficiently.
I can't think of the source right now, but in places where short selling has been banned, stock volatility rises.
Mike, if a company's only asset is a pile of money, then you can calculate exactly how much the company is worth. That is not a good company to short, or to buy at any price except $60 - brokerage etc fees, or for that matter to buy at $60 minus fees.
DeleteI don't think it "prices" a stock efficiently when a speculator tries hard to dishonestly manipulate the price downward.
I can't think of the source right now, but in places where short selling has been banned, stock volatility rises.
Well, duh! I buy stock because I hope the price will go up. If somebody shorts the stock enough to keep the price from going up, that reduces volatility!
Say I buy stock in company C at $50. They have some very promising opportunities, but they also have some challenges. It isn't a sure thing. Imagine the reality is that left alone, enough new investors will want the stock that they'll double the price to $100. Great! I'm happy. But instead you come in and you create six times as much virtual stock as company C ever released, and you sell it at falling prices to all the people who wanted to buy. They won't be nearly as eager to buy while the price is falling as they were when it was rising. They back off and the price is cut in half to $25. I'm not happy at all. But the volatility of the stock is less than it would be otherwise -- between $50 and $25 instead of between $50 and $100.
If there's a value to having market prices reveal supply and demand, what is the value when somebody can create virtual supply whenever he wants and distort the price? How does that help the people who need to use price to make production decisions etc?
"Well, duh!"
DeleteI actually do have some standards as to who I will discuss things with, and you just sunk below them.
Mike Sprout, I did not mean any offense.
DeleteMy point is that if a manipulator reduces the range that at stock price can travel, very likely that will reduce volatility as a result.
So if there is enough short selling to keep the price from going up, other things equal price volatility will go down. But this is not necessarily a good thing.
"Mike, if a company's only asset is a pile of money, then you can calculate exactly how much the company is worth. "
DeleteJ Thomas, Mike's example is only to simplify. Even if the company is more complex and has a number of working parts, that doesn't change the underlying dynamic. The company's stock will still have some fundamental value around which analysts will tend to converge over time. When a naked short seller pushes the price below that fundamental value, that seller has, as Mike puts it, "put itself on the wrong end of an arbitrage process." The market will drive the shares back up to towards fundamental value, and if it won't, the company's management will.
Here's my challenge for you. As I said in the last line of my blog post, explain why you also believe that banks inevitably create hyperinflation.
"Here's my challenge for you. As I said in the last line of my blog post, explain why you also believe that banks inevitably create hyperinflation."
DeleteBanks don't inevitably create hyperinflation. In the last good long time there have only been 37 examples of hyperinflation. Experience tells us that banks don't inevitably do that in any reasonable time.
In times of poorly-regulated wildcat banking, banks that got too overextended tended to be attacked by other banks who would collect a pile of obligations and present them to the weak bank all at once, hoping to trigger a bank run.
In normal times, government regulates banks to prevent them doin anything too much out of line.
When there is a consensus about a company's fundamental value, short sellers will have a hard time taking the price lower than that. They do better when there is no consensus. Like, a company can be worth less than its book value if its business model is failing. If it stopped running as a business and sold everything and distributed it to stockholders, it would be worth that. But it won't do that, it will keep trying to operate and if it starts making money that's fine, but if its debts keep going up, its fundamental value today is not worth so much.
If nobody thinks its worth the current price then you can't get a good price shorting the stock. But if everybody thinks it's worth a lot then you can't drive the price down by shorting it. You have to pick the right stock.
This is an important difference between shorted stocks and bankloans. You profit by shorting if the price goes down, and inflating the supply helps drive the price down. But you profit by loans from interest whether the value of money goes down or not, and you profit more if the money deflates rather than inflates. So the incentives are reversed.
"In normal times, government regulates banks to prevent them doin anything too much out of line."
DeleteNo, the reason that banks can't create inflation has nothing to do with regulation. If banks increase the supply of outstanding dollars beyond the demand for dollars, and the price level starts to rise, the central banks can remove its own issue of dollar, thus re-equating supply and demand and returning the price level to target. Even if the banking system was completely unregulated and banks did many stupid wild cattish things, they could not create inflation, insofar as the central bank undertook the appropriate open market purchases/sales to offset their actions.
And vice versa, naked short sellers can't cause stock prices to crash.
No, the reason that banks can't create inflation has nothing to do with regulation.
DeleteWell, it's one reason if others fail.
If banks increase the supply of outstanding dollars beyond the demand for dollars, and the price level starts to rise, the central banks can ....
Well yes, the Fed can do a variety of things to palliate the result of bank choices, and I would class many of them as regulating banks. If despite regulation the banks inflated the money supply too much, the Fed could sell enough treasury notes to mop up the spill.
And vice versa, naked short sellers can't cause stock prices to crash.
Well, that depends. Think about the old days on the NYSE, when specialists managed stocks. The specialist could set the price at whatever he wanted, but he had rules and also some realities he had to cater to. He was not supposed to change the price more than one point per transaction (though it sometimes happened) and he was not supposed to do part of a transaction at one price and part at another (thought that sometimes happened).
If he walked the price too low and too many gamblers bought at a low price, he lost money until he raised the price. But it helped that some gamblers stop loss orders, and he could sell their stock on the way down.
So he could take the price very low provided there were more gamblers who sold to limit their losses, than there were gamblers who thought the price was a bargain and bought even though it was still dropping.
And if he wanted to sell low even though there were no stockholders who were ready to sell at that price? He could sell all the naked shorts he wanted. But if he couldn't get others to sell to him at low prices then he was putting himself in trouble.
He could do whatever he wanted to the stock provided the gamblers in that stock were timid. But if there were too many cash-rich gamblers who disbelieved the EMH and thought a low price was their chance to make big profits, who refused to believe that the price reflected somebody else's knowledge about the company which they didn't share, then even a specialist's naked shorts would fail to drop the price very far.
But you're populating your highly stylized market with only gamblers and not including arbitrageurs. A company who's shares fall below fundamental value because of naked short selling can increase per share earnings by simply repurchasing and canceling shares. They'll continue to do so until the share price has returned to fundamental value. It's free money. To assume that naked short selling causes large, permanent, and unwarranted collapses in share prices is to omit this arbitrage.
DeleteA company who's shares fall below fundamental value because of naked short selling can increase per share earnings by simply repurchasing and canceling shares. They'll continue to do so until the share price has returned to fundamental value.
DeleteJust as banks don't lend large sums to just anybody, people who are in a position to do large naked shorts must carefully choose their stocks.
Don't pick a highly profitable company that has lots of cash lying around that they can at any moment choose to buy back their stock with.
I am not in that business, but I expect they would choose companies where nobody knows what the fundamental value is. For example, a company whose sales are down, that is about to come out with several new product lines which might do very well or might not. If one of them is a hit then the company will do fine for awhile, if none of them are then the company must try again and might possibly go under before sales go up.
A gambler who *believes* in the company might buy more and more stock as the price goes down, because he's sure it will be a good stock to own in the long run. Enough investors like that will stop attempts to drive the price down.
And a CEO who has the luxury of propping up his company's stock price whenever in his opinion it is too low, likewise.
But if the company needs its cash to do a big rollout, the biggest of the costs before the first returns, the advertising blitz etc, that might not be the best time to do a big stock buyback. Of course they could take out loans to buy back stock....
The guy who says that short selling doesn't affect the company, isn't talking about the company that cuts back production so it can spend the money to buy back stock.... "Never mind market share. The best use of our corporate funds is to buy back our own stock. It's free money."
My own thought is to let the people who actually own stock in the company decide what price they're willing to sell for. There's something wrong with creating virtual stock to sell at low prices, when the actual owners don't want to sell that low.
Nick:
ReplyDeleteWhat if the BOC's assets were mostly real bills, payable in 30 days or less, and were of adequate value to buy back all the dollars the BOC had issued? Do you still think commercial banks would then cause inflation?
Not sure what you mean by "economic difference". Let's say that 1 million genuine shares of microsoft exist. The short sellers issue 4 million hypothecated shares, either directly, by writing and selling 4 million IOU's that say "IOU 1 share of GM", or indirectly, by borrowing genuine shares, selling them, borrowing them again, selling them again, etc. Either way you end up with 4 million hypothecated shares pyramided on 1 million genuine shares, and either way, the assets and liabilities of GM are unaffected.
Mike:
Delete1. It depends on whether the BoC chooses to buy them back, to keep inflation on target.
2. "Either way you end up with 4 million hypothecated shares pyramided on 1 million genuine shares, and either way, the assets and liabilities of GM are unaffected."
Yep. I would say there's no economic difference. Or, I can't see any economic difference.
Nick:
DeleteOK, a few scenarios with the BOC:
1) BOC issues lots of new $ in exchange for short term real bills of adequate value (STRB's), and then dumps the STRB's in the ocean. Inflationary?
2) BOC issues enough new $ to keep up with economic growth, and dumps the STRB's in the ocean. Inflationary?
3) BOC issues lots of new $, keeps the STRB's, and announces that it will use the STRB's to buy back $, but not for ten years.
4. BOC issues lots of new $, keeps the STRB's, uses them to buy back BOC $, but the commercial banks start expanding checking account dollars faster than the BOC $ reflux to the BOC. Inflationary?
"Short selling" typically involves selling somebody else's liability. Bank deposits are the liability of the bank that issued them. Banks don't sell each other's deposits other than as traders of marketable deposit forms.
ReplyDeleteOn the other hand, assets in generally can be considered long positions and liabilities in general short positions.
I see nothing unique in banking relative to that second generalization. It applies to any corporate structure. The fact that banks can create money out of thin air is secondary to that principal liability characteristic I think.
"Bank deposits are the liability of the bank that issued them."
DeleteSo is shorted stock. Basically the trader has created and issued their own liability, denominated in terms of a stock, say MSFT.
I think your second generalization makes a lot of sense.
the stock is not the liability of the short seller
Deletethe promise to deliver the stock to the buyer on settlement day is a liability
and the borrowing of stock is a liability
but the stock itself is not a liability of the short seller
(nor is a shorted bond issued by a third party)
there's a difference - second versus first order
which I think is important to the logic of all this
fundamental to the difference between bank deposits and shorted instruments as far as that's concerned
Do these naked short sellers have terms? I am selling you a share of microsoft to be delivered in 10 days? Or do they sell for immediate delivery?
ReplyDeleteSuppose a trading house is buying and selling shares. When they sell a share, they don't worry whether they have it in inventory. When they buy a share, they don't worry if they have enough cash to pay for it. Periodically, they clear and make deliveries. They sell some shares, buy some shares, borrow some cash.
They have done some naked short selling.
Banks are more like that. The loan department makes loans without worrying about how they will be funded. The deposit department takes deposits without worrying about how they will be used. The money managers sell liquid assets or borrow short to clear--in the U.S. to meet arbitrary reserve requirements. Some of the loans where like a naked short sale of base money. The bank has to come up with the cash for such loans when the borrow spends them and they get deposited at other banks.
Somehow this doesn't quite fit in with a scenario where there is some conventional lag in delivery (I sell this morning and must deliver by 5) and my plan is to buy the shares later.
In banking, even if a loan is made now and the plan is to get a deposit later, the bank still has the loan and the deposit.
Anyway, naked short selling seems closer to selling futures contracts than banking.
The more in-depth mechanics of a naked short involves a dealer that makes a market in a certain stock. Sometimes they sell without having any inventory. They usually settle in three days by delivering the shares. But they can fail to deliver (within certain limits) so that their IOU stays outstanding... and they can keep on failing again and again so that those IOUs never expire.
DeleteI'm not sure your comparison is quite right in terms of who is in what position. With a dollar loan, the borrower typically spends the money so the deposit ends up in someone else's hands. So the depositor has a long position in dollars, the borrower has a short position in dollars and the bank is flat. That doesn't seem to fit with the bank being the equivalent of a short seller.
ReplyDeleteThe analogy may or may not have a perfect overlay in terms of position (am too tired to think right now). But the point of similarity between the banker and the short seller that I was trying to stress is that each can sell an item they never owned to begin with, and they go about this by replicating that item in IOU-form. Another similarity (I didn't get into this in the post) is that each of these IOUs is fixed not floating, and they can both be called on demand.
DeleteNick E.:
ReplyDeleteThe confusion here is that it’s not the banks that create the money; it’s the borrowers.
Scenario #1: I buy a loaf of bread on credit, handing the seller my paper IOU for $1. I have just gone short in dollars (and long in bread) as I issued one hypothecated dollar (my IOU).
Scenario #2: I borrow $1 from the bank by handing my $1 IOU to the bank, while the bank creates 1 checking account dollar for me. I buy 1 loaf with that checking account dollar. I’ve gone short in dollars and issued 1 hypothecated dollar. The bank has accepted my IOU and issued their own IOU, so the bank is flat (neutral).
In both cases, it was actually the borrower that created the new dollar. The bank was just the intermediary.
Bill:
Short positions generally have terms, but if, for example, I borrow 1 share of GM and sell it to you, and if you decide 1 week later that you want out, while I still want to stay in, then the broker who arranged the deal between us will just find another buyer to take your place. I get to stay in as long as I want, as do you.
Good point.
DeleteIt has sometimes struck me as odd that people talk about banks as creators of money, when clearly both bank and borrower are involved. I guess it depends on whose decision is most relevant. Sometimes that might be the borrower (such as when they decide to draw on a pre-agreed line; sometimes it might be the bank, such as when the bank decides to approve a loan request).
Typo:
ReplyDelete"if you decide 1 week later"
should have said
"If the stock lender decides 1 week later"
Suppose BMO’s investment bank borrows TD stock and sells it.
ReplyDeleteI.e. a “regular” short.
Suppose instead BMO sells TD stock without borrowing it at the time of sale. It can do this because there is a time gap between trade date and settlement date (or more generally, trade timing and settlement timing). At the time of the trade, BMO in fact does not hold the TD stock (by either owning or borrowing it) that it must deliver to the stock buyer in order to settle the sale transaction.
I.e. a “naked” short.
BMO has the obligation to deliver TD stock by settlement day for the transaction that initiates a regular short position (or possibly extend the term of the naked short position).
The naked short is a contingent front end to the regular short.
Consider a deposit that BMO issues.
Think of this as a callable bond.
Question: When BMO creates a deposit in conjunction with debiting a loan balance, is BMO analogously naked short the deposit as it is with the case of shorting TD stock?
I would say no.
Even if BMO is considered as short the deposit/bond, it is never “naked short” in the sense that it has to acquire the deposit/bond that it shorts – because it delivers the deposit liability without any requirement to acquire it from a third party.
The deposit liability is automatically delivered to the customer as a customer asset when the transaction is settled. There is no upfront requirement to cover the initiation of this obligation by borrowing or purchasing the instrument that is issued. There is no chance for a “fail”, and there is no settlement risk as typically associated with naked shorting. BMO controls the process totally, so it is not naked short in an analogous way to being naked short in the case of selling TD stock.
....
...
DeleteNow consider BMO in the context that it is short dollars in respect of its deposit liability obligation.
Question: Is BMO also naked short on the dollars that it owes according to the deposit liability contract?
Perhaps, but I think this is not a very strong analogy.
Whether BMO nets a reserve balance from another bank as a result of attracting funds from a deposit that already exists elsewhere – or creates a new deposit in conjunction with creating a new loan – in either case BMO is short dollars in the gross balance sheet sense.
And the fact that BMO effectively exchanges a loan for a deposit doesn’t mean that it is not in a position where it has borrowed dollars after the fact. It has effectively borrowed dollars because it owes dollars in that sense.
And if BMO nets reserve balances from another bank as a result of issuing a new deposit against existing money, and if BMO is on that basis considered not to be “naked short” as a result of that transaction, it is still the case that BMO will deploy those reserve balances in acquiring other assets as part of its ongoing liquidity and asset liability management. So, even if BMO is consider not to be “naked short” in the case of attracting existing money, it will soon become the equivalent of the purported naked short (in the case of a new loan/deposit) or nearly naked short as a result of ongoing liquidity management.
So the case is not strong for a characterization of naked shorting specific to the case of deposits created in conjunction with newly created loans – because standard liquidity management will create essentially the same position in the case of deposits that already exist in another bank.
I’d characterize the typical bank balance short as being short dollars on deposit and other liabilities, long dollars on assets, and net short or net long according to the desired granularity of specific asset and liability classifications, and according to timing gaps in expected cash flows due from assets or to liabilities. In that more granular classification context, a bank is net short in respect of dollars owed on its deposit liabilities.
And I think this is where 100 per cent reserves come into play as perhaps the “best” hedge against being short dollars on deposit liabilities.
In the context of your paradigm, this balance sheet granularity perhaps depicts a sort of “naked shorting” of dollars owed on deposit - on a stock basis - because all bank deposits were originally created as a result of injections from the asset acquisition side – with the exception of those that may have been created as a result of direct central bank reserve balance injections. To the degree that assets don’t look like deposits, the aggregate deposit position is “naked” or unprotected by assets with exactly the same cash flow. But that discrepancy is just a matter of standard asset-liability cash flow differentiation, which is what banking is all about.
So I would de-emphasize the analogy with (naked) shorting of 3rd party securities.
"Even if BMO is considered as short the deposit/bond, it is never “naked short” in the sense that it has to acquire the deposit/bond that it shorts – because it delivers the deposit liability without any requirement to acquire it from a third party."
DeleteA naked short seller of Microsoft can ignore convention and fail to deliver after three days, creating a permanently outstanding IOU. But at some point the holder of that IOU will want to convert that IOU into an actual Microsoft share, at which point the naked short seller will be obliged to acquire the physical Microsoft shares, deliver it, and thereby to settle the outstanding MSFT-denominated IOU it has created.
In the same way, BMO is much like the naked short seller. Having created a deposit, at some point the owner of that deposit may want to cash it in for paper bills. BMO will have to acquire the physical paper dollars to settle the outstanding deposit it has created.
To confirm then - are you using “naked shorting” as an analogy applied to banking in the sense that banks hold fractional rather than 100 per cent reserves against deposits?
DeleteIf so, does covered shorting analogize to 100 per cent reserves?
DeleteDoes it analogize to that plus 100 per cent conversion to physical dollars?
"If so, does covered shorting analogize to 100 per cent reserves?"
DeleteIf you own 1000 shares of CGI and you never short more than 1000 shares, that's like 100 percent reserves.
If you and a bunch of your friends short CGI to the point that there are 4 times as many shares of shorted stock circulating as there are "real" stock in existence, but you hold 20% as many shares as you have shorted -- in the form of shorts issued by your friends -- then you are like a bank with 20% reserves.
If you own a 1000 shares you're not short.
Delete"If you own a 1000 shares you're not short."
DeleteReason this out with me. If you own 1000 shares you can still go to your broker and sell 1000 shares short. Then if the price goes down you can buy 1000 shares cheap and close out your short position and then you own 1000 shares plus the difference in price between what your stock was worth when you shorted it and what it's worth now.
If the price goes up, you can close out your short position by offering up your stock. You then have the money you got by selling it short, which is less than what you would have if you had waited.
Kind of similarly, a bank that held 100% reserves and loaned only its own money, would never have to worry about a bank run.
A bank that lends other people's money is like a short-seller that sells other people's stocks.
Of course we're talking about old-fashioned banks from the days when there was an important relationship between deposits and loans, and when there was a significant reserve requirement. It's all changed now.
OK on the example then
DeleteI meant net short
i.e. not net shot - because the obligation under the short sale is covered by owning the stock at the same time
I still don't like the bank analogy
see:
http://jpkoning.blogspot.ca/2014/09/getting-naked-in-praise-of-naked-short.html?showComment=1411036993029#c6014536198566489756
"To confirm then - are you using “naked shorting” as an analogy applied to banking in the sense that banks hold fractional rather than 100 per cent reserves against deposits?"
DeleteNo, I'm using it in the sense that both a bank and a short seller create 'deposits'. One deposit type is denominated in a fiat paper instrument like the dollar and can be redeemed on demand in that instrument. The other is denominated in stock and can be redeemed on demand in stock.
And the second part of my analogy was that just like commercial banks can't influence the price level, ie. aka Nick Rowe the central bank is alpha, naked short sellers can't influence a stock's price, ie. the issuing company is alpha.
I don't doubt there are other parts where my analogy falls flat, most analogies do at some point break down.
The point of this post wasn't to say anything provocative about banking. It was to say something provocative about naked short selling of equities.
"And the second part of my analogy was that just like commercial banks can't influence the price level, ie. aka Nick Rowe the central bank is alpha, naked short sellers can't influence a stock's price, ie. the issuing company is alpha."
DeleteI don't agree that demand deposits (commercial bank) are beta and the central bank is alpha. Demand deposits can affect the price level.
JKH:
ReplyDeleteThe naked short analogy works fine for banking. You just have to recognize that it's not the bank that is short in dollars, it's the borrower. Anyone who borrows and sells a dollar is short in dollars, and anyone who promises payment in dollars is short in dollars. Banks have typically borrowed just as much as they have lent, so they are neutral in dollars.
Since the bank has borrowed short-term and lent long-term, they are "short" something, but what exactly is it?
DeleteJohn:
DeleteIf a bank borrows $100 payable in 1 month, and lends that $100 for 1 year, and rolls over the 1 month loan each month for a year, then that bank is not short in anything. It is neutral in dollars. It is, however, at risk of insolvency if the monthly rate suddenly shoots up. That's why smart bankers try to match the maturities of their assets to that of their liabilities.
Anyone who has borrowed is, in some economic sense, short their own credit risk.
DeleteJP:
ReplyDeleteWell, I should have said up front that I think this is a pretty brilliant post.
Although I’d approach the subject – if I was capable of capturing it as coherently - quite differently.
I’d start top down defining long and short positions (gross, net, short, etc.) for a balance sheet – probably a bank balance sheet.
Then later on I’d tease out the implied analogy for naked short positions – if that is a valid analogy – as a pretty minor characteristic.
The problem I see with it is that I think that naked shorting is too technical and narrow a focus for an analogous extrapolation to a larger balance sheet paradigm for banking.
It is a specific function of an exposure that exists between trade date and settlement date.
And that is a secondary exposure compared to the primary one of what exists in the main as settled asset and liability positions on a bank balance sheet.
JKH, thanks. I'll try and reply to your points tomorrow or this week. It's late and my brain isn't working right now.
DeleteThe analogy to naked shorting would be if banks literally printed Federal Reserve notes. That would be illegal counterfeiting. Creating an asset which is economically similar, but distinguishable, is not counterfeiting.
ReplyDelete"The analogy to naked shorting would be if banks literally printed Federal Reserve notes."
DeleteI don't think so. Naked short sellers are not literally printing Microsoft stock. They're creating IOUs denominated in stock. Counterfeiting MSFT share certificates is a totally different thing from the naked short selling of MSFT.
JP,
DeleteSo in a naked short situation, the stock has been sold - for future settlement - but the stock has not yet been borrowed.
Any idea what the accounting entries would look like for this?
There should be an asset and a liability.
And any idea what happens to the accounting entries upon fail?
btw, I think Bill Woolsey's comment comes closest to the difficulty I'm having with the idea
DeleteIn a naked short position the short seller has sold their personal IOU into the market, not the actual stock. That IOU represents a promise to deliver the stock upon settlement date in three days. Three days hence the short seller will borrow/purchase the stock, deliver it, and extinguish the IOU. They are no longer short. Alternatively, they can keep their IOU in circulation indefinitely via a long string of settlement failures.
DeleteIn terms of accounting entries, the naked short seller would have a liability to deliver the stock, and on the asset side they would have cash from the proceeds of selling their IOU. The owner of the liability is holding something that looks and acts like a stock, but that instrument is not the liability of the issuing company--it is the liability of the naked short seller.
The total size of balance sheet of the system would expand with a short sale, correct?
DeleteThat reads like the naked short seller receives cash before a covered short seller with the same trade - i.e. before settlement date for the stock sale.
DeleteSeems odd.
Is that right?
John, yes.
DeleteJKH, this is getting very back officish which is not my domain. If a stock trade fails to settle, I'm not sure if the cash leg of the transaction goes through or not. If it doesn't, then the naked short seller would still have a liability to deliver the stock, but on the asset side they would have a cash IOU.
Well, I still can’t see how this analogy is coherent - sorry.
ReplyDeleteWith a non-naked short you borrow the stock and sell it. With a loan/deposit combination, you borrow funds and sell them. You borrow by deposit and sell them for a loan asset. It just so happens that you create the funds you take in by lending them. There is no clearing of funds required – because the transaction occurs on a single balance sheet. It is circular – but funds have been borrowed (by deposit) and sold (in exchange for a loan). So I see this easily being analogous to a non-naked short. The deposit is analogous to the stock borrowing. The sale of the funds is analogous to the sale of the stock. The purchase of the loan is analogous to whatever the alternative investment is for the term of the short stock sale. So I see all of that as easily analogous to a non-naked short.
With a naked short, you owe the stock to somebody (presumably the buyer counterparty of your short sale). That’s just a debt. When it comes to covering that debt, it becomes a non-naked short sale as above. The only difference is the protracted timing differential between trade date and settlement date.
None of that has anything to do specifically with repaying a deposit with cash or with repaying a stock loan with stock. Whether the short sale of stock is naked or covered, you have to go out and buy the stock at some point. You are short stock. And in the same way if a depositor wants cash back, you have to pay that out of your reserve position (reserves of currency or purchasing currency with reserve balances).
There’s quite a difference at that point. The short sale requires 100 per cent coverage by buying stock at some point. The contingency of deposit repayment doesn’t – because all depositors don’t behave that way for 100 per cent of their deposit - that’s why reserves are so fractional as opposed to 100 per cent.
So I fail to see the analogy - and a fortiori I fail to see it hinging on naked as opposed to non-naked shorting.
P.S.
ref. Woolsey's comment again
JKH, I don't think that 'regular' short selling has an analogy in banking. With a regular short sale, you're borrowing the underlying instrument (Microsoft stock) and then selling it. The analogy to banking would be to borrow the underlying instrument (ie. paper dollars) and then sell/lend those paper dollars. But banks don't really engage in the business of lending paper dollars. They lend IOUs denominated in underlying paper dollars.
Delete"The short sale requires 100 per cent coverage by buying stock at some point. The contingency of deposit repayment doesn’t – because all depositors don’t behave that way for 100 per cent of their deposit - that’s why reserves are so fractional as opposed to 100 per cent."
ReplyDeleteAs one short position in stock is closed, another is opened, and there's a permanent float of hypothecated shares that are never really paid off. As one bank loan is repaid, another is taken out, and there's a permanent float of lent dollars that are never really repaid.
true, but a different point of macro symmetry
Deletethe asymmetry is that all shorts require ultimate repayment or cover in the instrument shorted
but not all bank deposits require ultimate repayment in central bank currency - few do
A short seller issues an IOU that says "IOU 1 share of GM stock"
DeleteA banker issues a checking account dollar that says "IOU 1 green paper dollar"
Sometimes, either of those IOU's will be settled by delivery of the underlier, sometimes they will be canceled clearinghouse fashion, sometimes they will be rolled over, and sometimes actual delivery won't be in the underlier, but in something of equal value.
Do you think that the relationship between a short seller of Microsoft and Microsoft the company is analogous in a way to the relationship between a commercial bank and its central bank?
DeleteI.e. both are leveraging the supply of the underlying?
If so, why is naked shorting critical to this analysis?
What’s the difference - whether or not the short seller has borrowed the stock from a stock lender or not?
Either way, isn’t it the same effective leveraging of the supply of the underlying?
Although I suppose that because naked shorting is less constrained, it would tend to increase the aggregate amount of leveraging, other things equal.
But why does the concept of the analogy between banks and short sellers depend on the naked aspect?
Whether a short owes stock to a stock lender or to somebody else doesn't seem to matter in the comparison. There's an exposure to the need to buy stock just as the banker is exposed to the need to buy central bank currency.
"Do you think that the relationship between a short seller of Microsoft and Microsoft the company is analogous in a way to the relationship between a commercial bank and its central bank?"
DeleteMaybe more like the relation between a bank and the Treasury used to be. The Treasury minted money. The bank inflated the supply of virtual money, on its own hook, reducing the value of the money. The short seller reduces the value of the stock by diluting it with virtual stock.
"What’s the difference - whether or not the short seller has borrowed the stock from a stock lender or not?"
What if it's the stock lender doing it? He doesn't have to borrow stock from anybody. But if the stock price goes up, at some point he has to actually buy and lose money when he does it, and the longer it goes up the worse it gets for him.
"But why does the concept of the analogy between banks and short sellers depend on the naked aspect?"
The naked part emphasizes that it's uncontrolled, unlike banks. If you have to get your stock from a broker, the broker monitors whether you are getting in trouble and issues a margin call if you are. After you get in trouble it's easy to go for broke, to invest whatever you can get into making sure the price goes down so you can win. Then you are likely to have a spectacular failure. The broker will stop you when he sees the risk, because he does not want you to owe him much more money than you can repay.
If that control is missing, then it's more like wildcat banking.
“Do you think that the relationship between a short seller of Microsoft and Microsoft the company is analogous in a way to the relationship between a commercial bank and its central bank?
DeleteI.e. both are leveraging the supply of the underlying?”
Except that the bank has both issued and received an IOU for $1, so the bank is not, on net, short in dollars the way a short seller of Microsoft is short in microsoft. It’s the bank’s customer, the original borrower of a $, who is analogous to the short seller of Microsoft.
Also, I wouldn’t say that any short seller of anything affects the supply of the underlier. The short seller only affects the number of claims to the underlier.
“If so, why is naked shorting critical to this analysis?”
It’s irrelevant. If you borrow a share and sell it, you create a hypothecated share. If you directly sell your IOU promising delivery of one share, you also create one hypothecated share.
“Either way, isn’t it the same effective leveraging of the supply of the underlying?”
Yes, subject to my reservation about the use of the word “supply”
“But why does the concept of the analogy between banks and short sellers depend on the naked aspect?”
It doesn’t, as explained above.
“Whether a short owes stock to a stock lender or to somebody else doesn't seem to matter in the comparison. There's an exposure to the need to buy stock just as the banker is exposed to the need to buy central bank currency.”
There’s that subtle ambiguity again. The bank is not, on net, short in dollars, but the short seller of Microsoft is short in Microsoft. The bank’s need to buy central bank currency thus arises from a different cause than the short seller’s need to buy Microsoft.
I think I agree with all that, thx
Deleteits a different approach than what's presented in the post
"The bank is not, on net, short in dollars, but the short seller of Microsoft is short in Microsoft. The bank’s need to buy central bank currency thus arises from a different cause than the short seller’s need to buy Microsoft."
Deletemaybe that captures the difficulty I've been having with this
A bank is short a call option on CB currency.
DeleteThat’s different than being short CB currency or being short Microsoft stock.
Can you be short CB currency, as opposed to simply being short dollars?
Delete"A bank is short a call option on CB currency."
DeleteTrue; a call with a strike of zero and no expiration. But the bank is also long in the dollars (or calls on dollars) lent to it by its customers.
"It’s irrelevant. If you borrow a share and sell it, you create a hypothecated share. If you directly sell your IOU promising delivery of one share, you also create one hypothecated share."
DeleteI don't think it's irrelevant. Bank's don't lend by borrowing a paper dollar, then selling/lending that paper dollar, then re-borrowing that same paper dollar and re-selling/re-lending it, etc etc. In other words, they're not doing what plain short sellers are doing. Banks create an IOU (denominated in terms of paper dollars) at the outset and subsequently sell/lend that IOU. ie. They're acting like naked short sellers.
Name me one bank that acts like a short seller.
"Banks create an IOU (denominated in terms of paper dollars) at the outset and subsequently sell/lend that IOU. ie. They're acting like naked short sellers. "
DeleteI didn't mean to say that banks lend by borrowing a paper dollar. I meant that when a bank issues a new checking account dollar on loan, the bank gets the borrower's $1 IOU in exchange, so even though the bank's loan, by itself, is a naked short, the bank's receipt of the borrower's IOU cancels that short and leaves the bank neutral.
BTW: I think we're coming up against a defect in the dictionary definition of "naked short". Here's my idea of a "covered short": A farmer has a wheat crop in the field. He promises to deliver 1 ton of wheat next month for $200 payable next month. The promise is covered by the wheat in the field, so even though the promise by itself is a naked short, on net the farmer is neutral in wheat.
But if I borrow 1 ton of wheat and sell it, that's not considered a naked short, even though I am exactly as uncovered as if I had promised delivery of 1 ton of wheat that I don't have.
Yes, that's right. The distinction doesn't have anything to do with being covered since someone who is naked short can be 'covered' while someone who is short can be 'uncovered'.
DeleteIf I had to imagine a bank that only engaged in regular shorting (not naked shorting) it would be a bank frequented by criminals, since criminals require loans in cash in order to run their businesses. The banker would have to convince other criminals to deposit their cash at the bank (in return for an IOU) so that he/she would have cash on hand to lend.
The criminal bank could create large quantities of IOUs by constantly borrowing new cash and re-borrowing cash already lent out. But I don't think it could ever create IOUs as fast as a bank that engaged in naked short selling... ie. selling IOUs outright without borrowing the underlying cash.
When I say that banks are naked short sellers, not short sellers, I'm just saying what the MMT folks always say --- that banks don't lend out reserves.
JP
ReplyDeleteA very LONG comment follows, sorry.
But it’s an intriguing discussion, touching indirectly at least on a lot of interesting aspects about the reserve system (you noted one in your last comment above - September 20, 2014 at 8:13 PM).
I’m thinking of posting this overall analysis separately at MR.
So I'm taking the liberty of offering it here as a comment as well - for continuity of discussion - if anybody is interested.
JKH
“Just as an equity short seller will borrow and then sell Microsoft with the intention of repurchasing it at a better price, bankers borrow and then sell dollars with the intention of repurchasing them at a better price… In the previous paragraph you may have noticed that I described banking as the borrowing of depositors' dollars in order to lend those dollars out. Because the dollars were borrowed prior to sale, this would qualify their activity as regular short selling, not naked short selling. But hold on, this isn't at all how banks function. Bankers don't wait for physical Federal Reserve dollars to be deposited by the public before selling them away… Banks are engaged in naked shorting pure and simple: they sell a financial instrument that they never actually had in their possession… How do they do this? The key here is that banks don't actually sell Fed paper dollars short, rather, they sell dollar-linked IOUs (i.e. deposits) short.”
DeleteThe post essentially says (I think) that banks engage in a sort of naked shorting exercise when they create deposits “ex nihilo” – that is without actually borrowing some form of funds in that process. Banks just issue new deposits to customers who take on new loans for example. Banks “acquire” a new loan asset without having “borrowed” “actual” “funds” to do so. So in a sense they have “sold” money (in exchange for a loan asset) without having borrowed it in the first place. Hence they are “naked short” in that sense. I think that’s the intended meaning, roughly.
An interesting question then is – naked short relative to what precisely?
Consider the counterfactual where bankers do wait for those dollars to be deposited before selling them away. According to the post, banks are naked short by comparison to such a counterfactual monetary system.
In this counterfactual system, it would seem there are at least two ways in which new deposits suddenly appear.
First, a bank customer can transfer or be the recipient of a transfer of money that already exists in deposit form in another bank. That transfer doesn’t change the level of system bank deposits. It happens through the bank reserve clearing system, and that is really no different than what happens today in the existing system.
Second, a customer can deposit central bank money in the form of banknotes. That DOES expand the level of system commercial bank deposits. And that is what would be different about this counterfactual monetary system. The level of system deposits in the counterfactual system – it would first appear - cannot expand in direct conjunction with new loan creation, but it can expand through new deposits of central bank money. This suggests a picture of central bank money circulating with a velocity that allows for banking system deposit expansion, assisted by a pace of central bank money expansion that boot straps that velocity. Conversely, in the monetary system that we actually have, customers who are granted new banking system deposits aren’t necessarily required to bring new funds into their bank to do so – in particular, a deposit customer doesn’t need to bring central bank money (banknotes) into a bank branch in order to receive a new deposit (i.e. a deposit that is both new to the bank and incremental to the level of already existing system bank deposits) – provided that customer can simultaneously borrow the funds from the bank.
But is this distinction between factual and counterfactual system actually meaningful?
DeleteThe question at this point becomes how are new loans created in such a system? We know they don’t come into existence by simultaneous loan/deposit creation at a single bank.
One way a new loan can be made is by a commercial bank paying out central bank money (in the form of banknotes that it keeps in reserve) when it makes a loan.
What happens to that central bank money? What happens to those banknotes? Well, they are used in commerce until somebody deposits them back in a bank. And then they end up in that bank’s reserve account, along with other banknotes and reserve balances. Other things equal, the lending bank will have a reserve deficiency and the deposit taking bank will have a reserve excess. Those aberrations will be sorted out as necessary by each bank taking steps in the money markets in order to balance their reserve positions as desired.
But that is what typically happens in the existing system. The borrower will typically use the new funds in commerce and those funds will find their way to another bank. It is the same result. A new loan and a new deposit have appeared on the banking system balance sheet, and the result looks like the same type of “endogenous” money creation at the system level that already happens in the monetary system we actually have, once positions associated with the original loan and its associated deposit have been cleared. The counterfactual system simply skips the initial step in which a borrower has both a loan and a deposit with the same bank. But otherwise, endogenous money creation carries forward at a systemic level.
And what happens if the deposit that is created in this counterfactual system ends up landing back at the same bank that issued the new loan? Well, essentially that lending origination bank now has a new loan and a new deposit. The only difference from the case of the existing monetary system is that the loan and the deposit are issued to different customers now. But otherwise, the net balance sheet result is exactly the same, including the fact that the bank’s reserve account hasn’t changed on a net basis. A new loan and a new deposit have appeared on the banking system balance sheet, and in this case on the balance sheet of a single bank – similar to what happens in the existing system. So the net result looks like the same type of “endogenous” money creation that already happens in the monetary system we actually have at the level of a single bank.
Let’s take this one step further. For example, what is to prevent a borrowing customer in the counterfactual system from depositing central bank funds he receives from a new loan directly back as a deposit with the same bank he borrowed them from – even if temporarily? Is that going to be precluded as a counterfactual system constraint? This seems absurd.
So what purpose has been served by this counterfactual restriction whereby customers must deposit central bank money in order for system deposits to expand?
I see no constructive answer to that. This counterfactual system makes very little sense as a useful modification to the existing system.
A counterfactual system which precludes immediate loan/deposit expansion is really no different in effect from the existing system – even if you want to outlaw a borrowing customer depositing his own central bank money proceeds back with his commercial bank. Moreover, the idea that a bank with multiple, frequently transacting depositors needs to identify specific deposit monies before lending them out is a nonsensical impediment to standard bank liquidity management. Given the intra-day dynamics of money markets, the order of depositing and lending is largely irrelevant in this whole process of bank balance sheet management.
DeleteConversely, the existing monetary system bypasses a questionable if not useless counterfactual constraint requiring all bank customers to operate with central bank money - by allowing the simultaneous creation of loans and deposits.
“Naked shorting” as a conceptual framework for banking only lives logically when “regular shorting” can be visualized by comparison. That context requires a counterfactual monetary system. And that counterfactual monetary system would seem to be a pointless tweaking of how the existing system operates. Indeed, “naked shorting” is fundamentally equivalent to “regular shorting” in the same context – as suggested above – just by visualizing a virtual flow of central bank money that connects the two key points of joint origination of balance sheet expansion - loans and deposits.
In summary, there is no problem in referring to bank assets as long positions and bank liabilities as short positions – in a relatively simple measurement paradigm of long and short gross balance sheet items from the perspective of the bank. (This is essentially the terminology of hedge funds.) An appropriate methodology (if desired) can then be chosen for netting such gross measures to a coherent summary of net “longness” or “shortness” for various types of exposures. At a high measurement level, a bank is net flat by virtue of a balanced balance sheet. But there are all sorts of ways of drilling down and becoming more granular in the description of effective net exposure. This is what hedge funds do in the case of third party positions in both assets and liabilities. Moreover, this is also the essence of bank asset-liability management across all types of risk – including liquidity risk, structural interest rate risk, structural foreign exchange risk, and all types of trading book market risks. It’s a matter of specifying what the measurement methodology is for gross and net exposures. But it seems to me that given the inevitable reality of endogenous money creation and the sensible clearing short cuts inherent in that process, the underlying “non-naked short” idea from which the idea of “naked short” must be derived is itself quite dubious, making the associated concept of “naked short” a somewhat questionable although very interesting characterization of bank deposit creation.
One way a new loan can be made is by a commercial bank paying out central bank money (in the form of banknotes that it keeps in reserve) when it makes a loan.
DeleteSo the bank reduces its cash on hand when it makes a loan. And the debtor then deposits most of his cash in some bank -- maybe the same one, or another -- because he doesn't want to carry it around. Total reserves have not changed.
But if the bank is required by law to maintain 10% reserves, every time it makes a loan its reserves are hit by 100% of the loan and not just 10%. It has to get more cash. So to get $100,000 cash the bank must pay the Treasury $100,000 in deposits. Then it has enough cash reserves to make another $900,00 in loans.
Have I got that wrong?
Nice work if you can get it!
The central bank injects newly required reserves into the system through OMO - after the fact of new deposit creation.
ReplyDeleteNo different than the existing system and therefore not an issue here.
Wow, a significant uptick in the number of comments here JP... that works out to approximately 0.209 comments per naked person (and rising). Well, whatever brings em in I guess. :D
ReplyDelete