How Fails-To-Deliver Could Be Costing You Money

One of the common theories when it comes to short-selling in the stock market is that fails-to-delivers (FTDs) constrain informed short-selling and can result in overvaluation of underlying stocks. However, new research from George Mason University’s Thomas Stratman and John Welborn suggest the capacity to FTD can actually be used as a proxy for naked short-selling.

Naked short-selling is a process by which a trader agrees to sell shares of a stock that he or she doesn’t actually own or has not borrowed. The resulting FTD creates what are known as “phantom shares” of a stock that can lower the cost of borrowing shares and dilute the price of the underlying stock.

FT Alphaville’s Izabella Kaminska recently discussed the George Mason theory that FTDs are being used strategically to encourage ‘uninformed’ short-selling and are therefore weighing on market returns.

“Rather than being a means for ‘uninformed’ short-selling, these naked short sales are intended for the sole purpose of creating loanable inventory for informed short sellers (through the broker dealer network),” she said.

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Kaminska argued that the typical criticism of naked short selling is that it makes it artificially cheap to short-sell and results in uninformed market speculation rather than natural price discovery.

“If FTDs are indeed a function of increased informed short-selling, rather than a byproduct of short-selling constraints, then FTDs could be a cause of abnormal negative returns in markets or stock price depression, rather than the opposite.”

She also noted that inflated inventories for speculative short-sellers can be particularly dangerous during times of market crisis.