Are counterfeit shares and the "short ladder attacks" purporting to use them, real?
Hi, long-time SE user here. As I would like to attract users with actual industry experience or expertise, I'll be awarding +150 bounty to the best answer, and possibly +50 bounty for other informative answers.
I'm aware of Closing Shorted Positions via Short Ladder Attacks. There, the OP asked, "Why wouldn't hedgefunds keep using a short ladder attack?" to which someone answered that short ladder attacks are a fiction because NBBOs make them impossible. As someone with experience in the tech side of the industry though, I don't know if this argument is watertight—I explain why later. I don't feel extending discussion in comments there will work out, as the topic has numerous considerations, so I'm asking a question directly, with sources and quotes to focus argument.
The idea of "Short Ladder Attacks" appear to have originated from the 2014 source Counterfeiting Stock. I could not trace the author from the homepage or a WHOIS. Many have found this source through a Seeking Alpha article that referred to it, authored by Gerald Klein. (On this person I could only find several class actions they were a plaintiff in.1 2)
Are "counterfeit shares" real?
Whoever the author is, these are the claims they make. The numbering is influenced by paragraphs but also sometimes split by me; I'm trying to keep to one idea per number so people can refer to each clearly.
There are a variety of names that the securities industry has dreamed up that are euphemisms for counterfeit shares. Don't be fooled: Unless the short seller has actually borrowed a real share from the account of a long investor, the short sale is counterfeit. It doesn't matter what you call it and it may become non–counterfeit if a share is later borrowed, but until then, there are more shares in the system than the company has sold. [...] The creation of counterfeit shares falls into three general categories. Each category has a plethora of devices that are used to create counterfeit shares.
[a] Fails–to–Deliver — If a short seller cannot borrow a share and deliver that share to the person who purchased the (short) share within the three days allowed for settlement of the trade, it becomes a fail–to–deliver and hence a counterfeit share; however the share is transacted by the exchanges and the DTC as if it were real. Regulation SHO, implemented in January 2005 by the SEC, was supposed to end wholesale fails–to–deliver, but all it really did was cause the industry to exploit other loopholes, of which there are plenty (see [b] and [c] below). [...]
[b] Ex–clearing counterfeiting — The second tier of counterfeiting occurs at the broker dealer level. This is called ex–clearing. These are trades that occur dealer to dealer and don't clear through the DTC. Multiple tricks are utilized for the purpose of disguising naked shorts that are fails–to–deliver as disclosed shorts, which means that a share has been borrowed. They also make naked shorts “invisible” to the system so they don't become fails–to–deliver, which is the only thing the SEC tracks. The SEC does not examine ex–clearing transactions as they don't believe that Reg SHO applies to short shares held in ex–clearing. [The author goes on to list 7 examples.]
[c] [This one's so long I won't even bother to include it.]
It goes without saying that, admitting possibility of "counterfeit shares" does not mean short ladder attacks are real. (Trying to preempt misuse of this question for misinformation.)
Are "short ladder attacks" real?
And here are their claims regarding what they actually called a "short down ladder."
The Anatomy of a Short Attack — Abusive shorting are not random acts of a renegade hedge funds, but rather a coordinated business plan that is carried out by a collusive consortium of hedge funds and prime brokers, with help from their friends at the DTC and major clearinghouses. Potential target companies are identified, analyzed and prioritized. The attack is planned to its most minute detail. The plan consists of taking a large short position, then crushing the stock price, and, if possible, putting the company into bankruptcy. Bankrupting the company is a short homerun because they never have to buy real shares to cover and they don't pay taxes on the ill–gotten gain. [...] Typical tactics include the following:
[a] Flooding the offer side of the board — [...] The shorts manipulate the laws of supply and demand by flooding the offer side with counterfeit shares. They will do what has been called a short down ladder. It works as follows: Short A will sell a counterfeit share at $10. Short B will purchase that counterfeit share covering a previously open position. Short B will then offer a short (counterfeit) share at $9. Short A will hit that offer, or short B will come down and hit Short A's $9 bid. Short A buys the share for $9, covering his open $10 short and booking a $1 profit.
[cont'd] By repeating this process the shorts can put the stock price in a downward spiral. If there happens to be significant long buying, then the shorts draw from their reserve of “strategic fails–to–deliver” and flood the market with an avalanche of counterfeit shares that overwhelm the buy side demand. Attack days routinely see eighty percent or more of the shares offered for sale as counterfeit. Company news days are frequently attack days since the news will “mask” the extraordinary high volume. It doesn't matter whether it is good news or bad news. [...]
[cont'd] Global Links Corporation is an example of how wholesale counterfeiting of shares will decimate a company's stock price. Global Links is a company that provides computer services to the real estate industry. By early 2005, their stock price had dropped to a fraction of a cent. At that point, an investor, Robert Simpson, purchased 100%+ of Global Links' 1,158,064 issued and outstanding shares. He immediately took delivery of his shares and filed the appropriate forms with the SEC, disclosing he owned all of the company's stock. His total investment was $5205. The share price was $.00434. The day after he acquired all of the company's shares, the volume on the over–the–counter market was 37 million shares. The following day saw 22 million shares change hands — all without Simpson trading a single share. It is possible that the SEC has been conducting a secret investigation, but that would be difficult without the company's involvement. It is more likely the SEC has not done anything about this fraud. [More details at the source but also here.]
So, there you have it. There's a lot more at the source, but I think these excerpts give plenty of launching points for debunking or validating the idea of counterfeit shares and short ladder attacks.
Why I don't find the NBBO argument convincing enough...
Referring back to Closing Shorted Positions via Short Ladder Attacks, here's why I felt the answers and comments fell short of my trust. No disrespect to anyone there.
Any trader who bids less than NBBO to buy a security goes on the order book at a lower price as a limit order. The same holds true for a seller whose price is above NBBO. The only way that traders can move price is more buying (or selling) volume that is available at current price.
I just don't think that's necessarily true. (It might end up being true, but it's not a closed case for me.)
I know what an NBBO is—I've spent quite some time developing trading platforms—and in that time I've seen a staggering variety of exchange mechanics: dark pools, smart order routing techniques incorporating icebergs and stop triggers, funky exchange features like "mid-point dark crosses," groups of pegs that just sit outside like P+1, P+2, P+3, P+4, P+5. (And I thought I had seen that brokers can prefer executing against other specific brokers as long as they respect price priority.) Anyway, these examples aren't to argue that the NBBO can be violated (it can't), but I think the NBBO line of argument assumes that order books are comprised of static, vanilla limit orders that don't react to their environment. Correct me if I'm wrong, but I don't think retail traders (or "traders") make up most of the order book. It's institutions, and the order book is full of dynamic orders that do respond to sell pressure.
Given the technology I've coded for institutions, I can imagine a coordinated attack that drives prices down. I think. (Consider this a hypothetical, just to show it's not that simple.) Algorithms and technical indicators do respond to sell walls and high-frequency sell-offs. (You think there aren't hedge funds on the other side of this game?) Orders are pegged to the inside or they're "feelers"—they disappear or shift around as the inside moves. So not only can a coordinated attack bring on pressure, but, especially when there's significant profit to be made, why couldn't part of the strategy be to intentionally execute the inside at a controlled loss? As long as part or most of those executions are against your friends who are in on the scheme (i.e. have planted bids on every price level, especially empty ones—fractional prices come to mind), you would be able to feign high volume while forcing prices down, triggering institutional reactions and retail panic, so that you can ease off the gas and let momentum do the work—then gas on, gas off—maybe a couple million dollars sacrificed each time—but to make a billion later.
Again, that's completely made up. I just want to highlight that markets are sophisticated, and I would rather see a sophisticated answer ruling out why scenarios such as mine aren't possible or effective. But more importantly, why counterfeit shares and short ladder attacks as described in the source, Counterfeiting Stock, do or don't make sense.
I'm not trying to make short ladder attacks a thing. For full disclosure, I am surfacing from the echo chamber of WSB, but I also recognize all kinds of questionable analyses that have cropped up there—grasping at straws about SEC legalese, imaginative takes on basic things like T+2 Settlement, etc. I'm a long-time evangelist of the SE network and was surprised to see someone on WSB (r/wallstreetbets) link directly to this site, which is what motivated me to award bounties for a quality answer on the topic.