07

Aug

2015

Isaac Le Maire vs Patrick Byrne – short selling technology redux

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Isaac Le Maire is known for having sired 22 children. Quite an accomplishment. He may be better remembered for having “invented” modern short selling, see the “History” chapter of this wikipedia post.

This article from Overstock CEO Patrick Byrne recently caught my attention. Patrick, amongst other things, has been on a crusade to restrict even further naked short selling – see this wikipedia post here about naked short selling. Although I am sure bad actors use naked short selling for nefarious activities, I am unsure whether the practice is downright wrong per se or has a negative impact on the markets. I digress though as this post is not about naked short selling but about how short selling could be disrupted.

I do agree that the short selling market is in need of disruption for exactly the reasons Patrick Byrne outlines. Fat margins, opaque market, few actors making out like bandits. I do not agree with the solution he has come up with and this is why: Short selling, like any financial market, is driven by supply and demand. Both supply and demand are distributed along a power law, i.e. a small number of players make up most of the short selling volume. With every short sale you have two parties, the party that owns the stock and lends it, the lender, and the party that sells the stock without owning it, the borrower.

Back to the power law distribution: a) the lending side is ruled by Pension Funds, b) Hedge Funds and their Prime Brokers rule the borrowing side. Neither the Pension Funds nor the Hedge Funds will want to disrupt the current system if the Prime Brokers and the Custodial Banks will not participate – both are essential to performing any short sale. That is the key! Prime Brokers and Custodial Banks in all likelihood will not participate because they underwrite counterpart risk and need adequate compensation – after all short selling is a risky business. And finally Prime Brokers and Custodial Banks are hardly going to give their business away just because a new entrant says so. In other words short selling is a tightly integrated eco-system and peeling off a few actors or one side of the eco-system will not deliver meaningful traction. Power laws are usually an all or nothing affair.

So, where does this leave us with the TØ.com initiative – TØ is the Overstock subsidiary driving the short sell disruption project? If you cannot co-opt the main short selling actors, you will have a very tough time aggregating enough volume to truly disrupt the market. This will most probably leave the short selling eco-system enough time to assess any technology threat posed by distributed ledgers and respond appropriately.

Further, let’s assume Byrne’s initiative also angles to kill naked short selling outright by bringing transparency to the market via a distributed ledger paradigm. Let’s think through this for a second. In a way, naked short selling is the byproduct of the delayed settlement model of the current system. When one “buys” a stock one does not need to prove to the clearing house that one has the cash at the time of trade. Similarly when one “sells” a stock one does not need to prove that one owns the stock at the time of trade. The intermediaries extend credit over this trade-to-settlement process. As such, TØ will be faced with a marketing problem: why would a Hedge Fund want to borrow stock to short sell it on a platform that will flag any trade where the timestamp of a trade confirmation is sequenced prior to the timestamp of the loan confirmation? That will not work imho.

Again, I do believe the short selling market needs to be disrupted and will be disrupted. It is only a matter of time. And I do believe Overstock’s investment in Peernova was a very shrewd move as the tech team there is very sharp. Further I can only assume TØ is using Peernova to build its platform which is a vast improvement over the technology platform they may have used before.

Might we hear of business model pivot or refinement of their current model by TØ in the future, one that would address the issues I bring up in this post? I would not be surprised.

Might there be other startups and entrepreneurs that have very valid ideas as to how the short selling market should be disrupted and have the right subject matter expertise? Most assuredly.

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Pascal Bouvier
pgb2008@gmail.com

Life and work experiences have given Pascal an unmatched vantage point, seeing things as both venture capitalist and aspiring entrepreneur. He currently is a Venture Partner with Santander Innoventures – Santander Group’s Global Fintech fund.

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