Being Short and Right Can Be Bad

(Bloomberg View) -- Longfin.

Longfin Corp. is a company that emitted some nonsensical noises about cryptocurrencies and blockchain and thereby briefly became worth than $6 billion. There were two critical bits of luck or skill that allowed Longfin to get that valuation. First, it emitted its noises about blockchain at exactly the time when everyone wanted to hear noises about blockchain (last December, when it went public). Second, it had (and has) an extremely limited public float: It has 74.5 million shares outstanding but sold only 1.14 million of them in its initial public offering, though it was also allegedly doing some illegal unregistered share sales which I guess, technically, would increase the float. But the point is, people wanted to buy Longfin shares because they were seduced by the blockchain noises, and there weren't that many shares to buy so the price of those shares went up a lot, and then you had to multiply that price by the much larger number of Longfin shares that weren't available to buy to get its comically inflated market capitalization.

Lots of other people, though, were less seduced, and were extremely keen on selling Longfin. Well-known short-seller Andrew Left of Citron Research called Longfin "a pure stock scheme" whose filings were "riddled with inaccuracies and fraud," and said that Securities and Exchange Commission enforcement "should not be far behind." This is hard to argue with; the SEC brought an enforcement action about two weeks after he tweeted that. But he prefaced those comments with "if you are fortunate enough to get a borrow": Selling Longfin stock short was hard and expensive, because you need to borrow shares to sell them short, and pay a daily fee to keep borrowing them. Again, Longfin had an extremely limited public float, so there were not a lot of shares to borrow, and a lot of people who wanted to borrow them.

Another way to bet against Longfin was to buy put options on it, which give buyers the right to sell stock in the future at some fixed price. If you buy a put and the stock price goes below the put strike price by the expiration date of the put, you can exercise the put, sell the stock at the strike price, and buy it back at the lower market price. 

Anyone who bet against Longfin, by selling it short or by buying puts, seems to have been right, insofar as the SEC has accused it of fraud and Nasdaq has halted trading in the stock. Sadly, they were a bit too right for their own good: The trading halt means that Longfin cannot trade either on the exchange or over the counter, so it is stuck in limbo at its last price of $28.189 per share (a $2.1-billion-dollar market capitalization) from April 6, just before the SEC released its complaint. Not that you can buy it for $28.189; that's just the last printed price. You can't buy, or sell, it for any price.

If you are a Longfin short seller that is actually a problem! You bet that Longfin was a fraud, and the regulators seem to agree with you, but the regulators have also taken away your ability to profit from your bet, because you can't buy in the stock to close out your short position. Instead you are stuck in your short position, having borrowed the stock, and continuing to pay a lot to borrow it each day until trading resumes. We have talked about this problem recently; it is by no means unique to Longfin, but you don't usually see it in formerly-$6-billion companies.

If you are a Longfin put buyer it is also a problem. Jamie Powell at FT Alphaville wrote yesterday about the Longfin put options that expire today. "There are Longfin put options [on shares] expiring [Friday] which have a strike price of above are therefore, in trading parlance, 'in-the-money,'" he notes, and those option holders have a couple of problems. (Here is a Reddit thread of their grievances.) First of all, if trading in Longfin is halted if you can't buy or sell its stock then can the put holders exercise their right to sell the stock at the put price? The answer is yes, actually I guess delivery of shares underlying an option doesn't count as "trading" for a trading halt but it is more complicated than usual; while in-the-money options normally are automatically exercised at expiration, option holders on halted shares need to contact the Options Clearing Corporation to exercise their options. ("Let's hope Longfin bears got the  memo writes Powell.)

Second, even if you do exercise your put and sell your shares, you need to find shares to sell. If you already own shares, then that's easy, but I doubt there are too many Longfin put holders who also own shares. ("I'll buy some Longfin stock but hedge it with puts" does not seem like a common thought process here; either you're long or you're short.) If you don't own shares, you can't buy them -- trading is halted -- so you have to borrow them. But remember that it is difficult and expensive to borrow Longfin stock. So the put holders who exercise will exercise into a lot of pain.

There's one other problem. Powell writes about the Longfin options that are "in-the-money" because their strike prices ($30 and up) are above Longfin's current stock price. But Longfin doesn't have a current stock price. It has a last stock price of $28.189 as of April 6, but a lot has happened since then. (The trading halt, the fraud case ....) And there are thousands more Longfin options with strike prices below $30 that might be in-the-money, depending on what your view of Longfin's current stock value is. If you have a Longfin put struck at $22.50 that expires today -- and I see on Bloomberg that there are 1,997 of those options, with 199,700 shares underlying -- and you exercise it today, then you are effectively getting short Longfin at $22.50 per share, still almost a $1.7-billion-dollar market capitalization. Ordinarily you'd never exercise an out-of-the-money put just because you think the stock will go down -- it's better to let the put expire and just short the stock directly -- but here there's no other way to short the stock because it is halted. If you think Longfin is worthless then exercising your put is a good trade. If you think that shorting Longfin while it's halted is a nightmarish abyss, then exercising your put is a way to jump into a nightmarish abyss. Both of those beliefs seem perfectly plausible and consistent. So what do you do?

"Naked short selling" -- selling stock without either owning or borrowing it -- is a thing that has a bad reputation; it sounds risqué, and there is a widespread (though not especially correct) belief that it somehow creates "phantom shares" that can be used to manipulate the stock price. But as we have discussed beforelegitimate -- clothed -- short selling is a very risky way to bet against fraudulent companies. Even if you are proven entirely right in short order, there are enough weird ways to get squeezed stock borrow costs that you might lose money even as the stock collapses and the fraud is exposed. In fact, regulators exposing the fraud and halting the stock is one of those ways! In a sense, the flimsier a company is -- the more it relies on transparent fakery and thin float to rapidly create a multibillion-dollar valuation -- the riskier it is to short it. And if it's too hard to short the flimsiest companies, then you'll keep seeing ridiculous stories about flimsy companies with those huge valuations. 

Website website website.

Here's a story about how the shipping industry, which "still relies on millions and millions of paper documents," is pushing to get shippers, customers, banks, insurers, port authorities and others to stop filling out forms on paper and start filling them out on websites instead:

Should they succeed, documentation that takes days will eventually be done in minutes, much of it without the need for human input. The cost of moving goods across continents could drop dramatically, adding fresh impetus to relocate manufacturing or source materials and goods from overseas. 

“This would be the biggest innovation in the industry since the containerization,” said Rahul Kapoor, an analyst at Bloomberg Intelligence in Singapore. “It basically brings more transparency and efficiency. The container shipping lines are coming out of their shells and playing catch-up in technology.”

Oh fine fine fiiiiiiiine of course you know that the word isn't "website," it is "blockchain." The idea is not that you'd go to A.P. Moeller-Maerk A/S's website and fill out a form that Maersk would use to track your container; it's that you'd go to Maersk's website and fill out a form that Maersk would use to track your container on the blockchain. Sorry sorry sorry I will try again. The idea is that you'd go to a website maintained by some sort of industry-wide consortium, and you'd fill out a form, and rather than that form's data living in a proprietary database maintained by Maersk or even by the industry-wide consortium, it would live in a shared database maintained (on the blockchain!) by the shipping industry collectively, which might make the database more secure and reliable and adaptable and trustworthy, and perhaps more likely to be used. A national customs agency, for instance, might be happier approving shipments on an auditable open blockchain than in the proprietary database of a particular shipping company. 

That is the idea. The reality is of course that each shipping company has hired a technology company to build its own proprietary cargo-tracking website, I mean blockchain: Maersk "has teamed up with International Business Machines Corp. to enable real-time tracking of its cargo and documents using blockchain," and

APL Ltd., owned by the world’s third-largest container line CMA CGM SA, together with Anheuser-Busch InBev NV, Accenture Plc, a European customs organization and other companies said last month that they’ve tested a blockchain-based platform. South Korea’s Hyundai Merchant Marine Co. held trial runs last year using a system developed with Samsung SDS Co.

You do not quite get the benefits of trustless decentralization and seamless movement of commerce if each shipping company builds its own proprietary blockchain. If they really want to blockchain it up in here, "dozens of shipping lines and thousands of related businesses around the world -- including manufacturers, banks, insurers, brokers and port authorities -- will have to work out a protocol that can integrate all the new systems onto one vast platform."

It is perhaps an interesting data point that the shipping-blockchain project didn't start that way: Rather than all the big shippers coming together to agree on and build a vast new platform for the industry to use, each of them seems to be building its own system and hoping that everyone else adopts it. The problem of putting everyone on one system is not primarily technological: The securities industry built its own vast platform for every brokerage to agree on stock trades back in the 1970s, before the blockchain was a glimmer in Satoshi Nakamoto's eye. The problem is a social, coordination problem: You gotta get everyone to agree to use one system, blockchain or otherwise. The word "blockchain" gets people excited and so is useful in solving that coordination problem -- "come to the blockchain meeting!" is a lot more appealing than "come to the paperwork reduction meeting!" -- but at this point it may have had too much success. Why just go to the blockchain meeting when you can build your own blockchain? But if everyone does that then it won't work.

The crypto.

Speaking of emitting blockchain noises, this took some chutzpah!

Big Silicon Valley backers of cryptocurrencies have sought a broad exemption from federal oversight they say would slow digital coin growth ...

The group wanted formal assurance from regulators that their products would be exempt from SEC oversight, arguing the tokens aren’t investments but products that can be exclusively used to access services or networks provided by startup companies, people familiar with the meeting said.

Oh man, I hope they whipped out a laptop and showed the SEC staff all the actual working platforms that use functioning crypto tokens. "Look at this widely used network in which participants regularly buy goods and services using a crypto token," I hope they said, "and look how stable and non-speculative the price of that token is." I hope the screen was blank, and the venture capitalists had a glassy-eyed faraway look. I hope the SEC patted them gently on the heads and said "of course, of course."

Look, I am sympathetic to the idea that some innovation should be allowed in initial coin offerings, and that the fact that ICO tokens definitely seem like "securities" under existing precedent doesn't necessarily mean that the best policy approach is to subject them to all of our existing securities laws. The optimistic view of ICOs is that they enable a genuinely new way to fund and create ownerless networks, and in this age of overly powerful owned networks, that is something worth exploring and encouraging. But you do have to start from a place of honesty: "These are probably securities, so what do we do about it" rather than "hahaha what there is no speculation in the ICO market, what are you even talking about?"

Also:

The group said it wouldn’t object to the SEC intervening if a token issuer committed fraud, the people said.

How generous of them! Come on man. You can't walk into the SEC and say "blockchain!" and expect the SEC to reply "oh blockchain, I didn't realize you were going to say blockchain, never mind, do whatever you want, we won't interfere." Come on. Blockchain.

Oh Barclays.

A while back, an anonymous whistle-blower sent a letter to Barclays PLC's board of directors besmirching the reputation of a senior banker whom Barclays Chief Executive Officer Jes Staley had hired. Staley thought that this letter was an unfair and scurrilous attack and set out to identify the whistle-blower so that he could, presumably, call him a rapscallion or challenge him to a duel or whatever. This was pretty understandable on a human level, really, but also egregiously bad as a matter of whistle-blower policy: If your whistle-blower policy only protects anonymous whistle-blowers whom the CEO happens to agree with, then it doesn't really protect anyone.

This was all pretty embarrassing, and Staley apologized, and the board reprimanded him and reduced his compensation, and the U.K. Financial Conduct Authority and Prudential Regulatory Authority investigated, and they are now wrapping up their investigation and have brought their conclusions to Barclays:

The FCA and PRA are alleging that Mr Staley’s actions in relation to this matter represented a breach of Individual Conduct Rule 2 (requirement to act with due skill, care and diligence) and each have proposed that he pay a financial penalty. The FCA and PRA are not alleging that he acted with a lack of integrity or that he lacks fitness and propriety to continue to perform his role as Group Chief Executive Officer.

So the FCA and PRA came to the same place as the board: Staley should be embarrassed, reprimanded, and fined, but not fired. 

You don't see a lot of this: a big high-profile investigation into the personal misconduct of a bank chief executive officer that ends neither in exoneration nor in firing, but in "yeah it was bad but he can stay." It does seem, though, that the concept of venial sin is a useful one. This result sends the message that proper treatment of whistle-blowers is important (thus the fines and embarrassment), but not the most important thing, and that Staley got it wrong but can learn from his mistakes. I suppose that is debatable -- the experience of Wells Fargo & Co. shows how bad things can get if you don't take whistle-blowing policy seriously -- but the broader point is that there are surely some things that are bad enough to result in embarrassment and fines but not bad enough to result in the axe, and probably a project of the post-post-crisis banking regulatory world will be figuring out exactly where those lines get drawn.

Oh Deutsche Bank.

Happens to the best of us:

A routine payment went awry at Deutsche Bank AG last month when Germany’s biggest lender inadvertently sent 28 billion euros ($35 billion) to an exchange as part of its daily dealings in derivatives, according to a person familiar with the matter.

My extremely hypothetical and not-at-all-legal-advice advice to you is, of course, if anyone ever accidentally wires you $35 billion, you should take it and flee the country, but I guess it is not easy for "Deutsche Boerse AG's Eurex clearinghouse" to flee the country. Anyway Deutsche Bank got the money back. 

Surveillance.

Here is an amazing Bloomberg Businessweek article about Palantir Technologies Inc. that starts with an anecdote about Peter Cavicchia III, who "ran special ops for JPMorgan Chase & Co." with the help of Palantir engineers who were embedded at the bank and who "had to agree to wear shirts with collars, tucked in when possible." They built quite a toy for him:

Palantir’s algorithm, for example, alerted the insider threat team when an employee started badging into work later than usual, a sign of potential disgruntlement. That would trigger further scrutiny and possibly physical surveillance after hours by bank security personnel.

Over time, however, Cavicchia himself went rogue. Former JPMorgan colleagues describe the environment as Wall Street meets Apocalypse Now, with Cavicchia as Colonel Kurtz, ensconced upriver in his office suite eight floors above the rest of the bank’s security team. People in the department were shocked that no one from the bank or Palantir set any real limits. They darkly joked that Cavicchia was listening to their calls, reading their emails, watching them come and go. Some planted fake information in their communications to see if Cavicchia would mention it at meetings, which he did.

Um! Cavicchia was eventually forced out because he spied on a different internal spying effort (an investigation into who had leaked information about JPMorgan's electricity manipulation), which ... also um! There are important lessons here about our surveillance society, but the one that I want to draw your attention to is, if you work at a bank, (1) someone in a compliance/surveillance department is definitely reading your emails so (2) you should craft your emails with that audience in mind. Meaning, first, of course, definitely don't email about committing fraud or leaving for a better job; hopefully you already knew that. But once you've taken care of that, sure, go nuts, liven up their day a little. Put some fake information in your emails. Conduct an entire, fictitious, steamy romance with your own alternate email account, just to keep them entertained. 

Also, if you are a compliance officer who is reading this email not because you are a subscriber but because you are surveilling a bank employee who is a subscriber: Hi! This is a little awkward, but it's nice to meet you. If this describes you please shoot me an email; I'd love to hear more about you and whoever's email you're reading. 

Things happen.

Wells Fargo to Be Fined $1 Billion Over Consumer Missteps. Hedge Fund Titans Pull Money From Funds for Huge Tax Bills. Mt. Gox and the Surprising Redemption of Bitcoin’s Biggest Villain. Blackstone Results Top Expectations, Helped by Fee Growth. African nations slipping into new debt crisis. Robo Adviser Wealthfront Cuts a Fee to Appease Angry Investors. Shire rejects £42.4bn Takeda offer as Allergan rules itself out. With World’s Biggest FX Trade Shackled, Investors Get Creative. People are worried about an inverted yield curve. 'Fearless Girl' is moving to a new home. Robot successfully assembles an Ikea chair. Wenger Out

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.

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