This “explainer” is intended to supplement to this recently published story on illegal short selling.
Covered vs. naked
“Covered” short selling is a legal way to profit in a falling market. It serves an important price discovery function — i.e. allowing traders who believe a stock is over-valued to try to make a profit from the overvaluation by betting the stock will fall once other investors finally clue in. These traders sell borrowed stock they don’t actually own in the hope they can buy it at a lower price in the near future to give back to the borrower. This is considered “covered” if the investor arranges to borrow the shares or in less strict markets like in Canada, has some level of certainty that there are enough shares that can be borrowed.
Predatory or naked short selling, when a trader sells securities without assurance they’re available to borrow, is considered a form of market manipulation and is illegal in the U.S., Canada and many other jurisdictions.
What’s the problem?
Junior miners say illegal short selling is magnifying sector losses and limiting rallies in individual stocks.
They point to the removal of the “tick test” restrictions in Canada in 2012, which curbed short-selling activity by only allowing short sales at a higher price than the most recent trade. Since then, they say there’s been an explosion of algorithmic trading that pressures losing stocks lower, and is currently targeting their sector. They would like regulators to reinstate the rule.
What evidence is there of a problem?
Illegal short selling is difficult to prove because data that could point to manipulative activity isn’t required to be disclosed.
Power Nickel CEO Terry Lynch says that data from Connecticut-based ShareIntel, which helps companies track trades in their stock — including suspicious trading activity — shows that there’s a massive and persistent naked short position on Power Nickel shares. That imbalance has grown to at least 9 million shares over the last four months, or about 7% of the junior’s outstanding equity, representing shares that were traded but likely never delivered. The problem could be even worse, Lynch says, because even ShareIntel can only access 80% of the trading data.
Power Nickel filed a complaint with Canadian and U.S. regulators CIRO and FINRA (Canadian Investment Regulatory Organization and Financial Industry Regulatory Authority) in December, asking them to investigate brokers that it says hold much fewer shares in their depository accounts than its clients actually own.
What do failed trades have to do with it?
One indicator of naked short selling is failed trades. Fails happen when a security isn’t delivered or paid for when due (typically within two days of a trade). There are legitimate reasons for failed trades. But a 2022 study by CIRO predecessor Investment Industry Regulatory Organization of Canada (IIROC) based on data from 2015-2020 showed a higher correlation between high levels of failed trades in the junior market and short sales. In addition, in Canada there’s a lack of transparency around failed trades, with no requirement to disclose them, unlike in the United States, Australia and the European Union.
According to Canadian law firm McMillan, IIROC justified this previously by pointing to a 2007 study it conducted that showed failed trades were a small percentage of trades executed (0.27%). But a 2022 IIROC follow up study using data from 2015-2020 — after the removal of the tick test — suggests as a percentage of total traded volume, failures range from 3-19% depending on the exchange.
How else is Canada out of step with other jurisdictions?
Both the U.S. And EU have pre-borrow or locate requirements for short sales in place. The U.S. has settlement requirements aimed at preventing naked shorting (mandatory close-outs) with the EU is imposing its own (buy-in requirements) in 2025.
What do regulators say?
CIRO says it uses sophisticated algorithms to monitor trading and detect unusual levels of short selling coupled with significant price movements that could point to manipulative trading activity. It says that data shows the frequency of short sales on down ticks is relatively low, and that the rates of such sales are actually lower on exchanges that list junior securities than on other exchanges.
CIRO and the Canadian Securities Administrators plan to form a working group on short selling in early 2024. They say it will look at ways to strengthen requirements that traders secure or locate securities before entering a short sale order, as well as recent suggestions from its latest public consultations.
CIRO operates in its own echo chamber. They said there was no issues with short selling when we were given special access at Save Canadian Mining thanks to the insistence of the Ford Government. Their data is flawed we don’t believe it is transparent and even this data showed there was a problem. It was in our report to the Modernization Task Force. I signed agreements not to disclose but would assume the Task Force submissions should be publicly viewable and investors could see for themselves. Expecting CIRO from its echo chamber from the industry it’s supposed to regulate to actually find the problem is very unlikely to occur or it would have happened already and we would not have the TSXV trading at record lows in a very good commodity market!