(taken from anonymous)
Repo: John has a 10-year Greek government bond purchased in 2008 and plans to use it as an education fund for his children. Mr Knowitall agrees with John to borrow his bond for a month and promises to return the bond, and compensate John for the trouble with a small pre-arranged amount of money (say 20 euros). John agrees and so the bond is in the hands of Knowitall who, for a month, can do whatever he wants with it, as long as he returns it at the end of the month, along with the pre-arranged amount . This is what we know as a repo.
Spread: Bonds, much like the term deposits, have an interest rate, determined at the time of issue. When we talk about a 5-year bond of 1000 euro with a 5% interest, it means that the one who will buy it will make 50 euros per year, for the next 5 years. The spread is the difference of the interest rates paid by a country in relation to the rate paid by another country which we consider as a basis. So, if Germany currently pays 3% for 5-year bond and Greece pays 5%, then the spread is 2% or 200 basis points.
The price of a(n) (old) bond falls as the current interest rate rises in the same class of bonds. In short, when spreads of the 5-year bonds go up, everyone who owns older bonds of the same class (ie 5 years), are the first to lose. The state is indirectly harmed in two ways: (a) By its reduced reliability (those who buy its bonds lose) and (b) When new bonds are issued, these bonds will have a higher rate.
Short Selling: Mr Knowitall, who has John’s borrowed bond, sells it in the market for 1000 Euros. He waits a few days, and the price of the bond falls. Then he buys a similar bond (10 year bond, issued in 2008) for just 900 Euros. So, Knowitall sold a borrowed bond for 1000 Euros , he bought the same bond a few days later for 900 euros, and now has a bond which is the same as the bond he borrowed, plus 100 euros (1000-900 = 100). At the end of month he returns the bond to John, and gives him the agreed 20 euros of the 100 that he won and keeps the 80 euros for himself.
From the above process, we understand that John, who still has the bond, gets the shaft and the Knowitall , who has profited by the bond’s price fall, makes a pretty penny.
Naked Short Selling: Because Knowitall is a greedy bastard and wants to make more than the 100 euros the above process helped him make, he does this next: While he has only borrowed from John one 10-year bond worth 1000 euros, he sells in the market 10 bonds worth 1000 euros each. In fact, 9 of these bonds sold there do not exist; they are bare (naked). This is a very dangerous practice of short selling, as there is no limit as to how much bare bonds can one sell. In the simple short selling, the limit is the bonds available in repo loans.
That way, one can create a virtual oversupply of bonds in the market, resulting in the bond prices sinking faster than the MS Estonia. Practically, the devaluation of the bonds becomes a self-fulfilling prophecy and all the person who made the naked selling has to do – taking advantage of the panic he created – is to buy these 10 bonds back at significantly lower prices.
The Bank of Greece, after a TL;DR and deliberately cryptic letter acknowledged that the above practice (the naked short) was tolerated because of an existing loophole, and we will immediately elaborate.
When someone sells a bond in the market (Electronic Secondary Securities Market owned by the Bank of Greece), he is required to deliver it to the negotiators within 3 days so the bond reaches the hands of the buyer. This is known as T +3. So there is the possibility to sell a bond you don’t currently have. So you owe the negotiator a bond and you have to deliver it in 3 days. If you re-buy it after two days from the same negotiator, then the negotiator connives and practically cancels your debt (because you sold one bond, bought one, the sum in bonds is zero).
This is practically an act of naked short selling as at the time you sold the bond, you were not required to actually possess it (or to have borrowed it, as described in the repo).
Since 3 days is usually too short a timeframe for the bond prices to change, no one normally does naked short selling this way. For any naked short seller to profit from a situation like this, there has to be a ridiculously steep price drop in only 3 days.
The backdoor of the Bank of Greece
This is the normal procedure. But in this process there was a backdoor that the BoG had deliberately left open. And this loophole was failed orders. So, when someone sells a bond, he has to deliver it within 3 days. If he doesn’t, then the transaction is ‘failed’. Failure doesn’t mean that the transaction is void, because the sale has been made, and there is a buyer waiting for his bond. If the seller delays the process, it can go on for even 10 days. But if he carries it too far, then the negotiator has to buy a bond himself, give it to the buyer and send the bill to the seller. But this is unlikely to happen, because the seller knows what he can get away with.
In this manner, a Greek bond seller could keep his position open for 10 days, without possessing the bond he had sold. He could practically have a naked short order, with no one holding him accountable.
In October 2009, the Bank of Greece took a decision to further simplify this process by facilitating anyone who wanted to play this loophole. We explained above what a dangerous game and practically illegal naked short orders are. Combined with the backdoor opened by the Bank of Greece and the constant flow of “made-to-order” articles on the Greek crisis, it is clear that what we had here was a recipe that allowed anyone to run naked short orders for at least 10 consecutive days.
This went on for quite a while, until April 8, when things got out of hand. The committee that controls the Electronic Secondary Securities Market decided to close the loophole of failed orders with the following way: For every ‘sell’ order, the seller must provide a repo (a borrowed bond of one day) until he could provide an actual bond.
No comments:
Post a Comment