T.S. Eliot is a poet of our time strictly in the latter sense. He has an eye for the social ills as they affect individuals. Of particular interest to him is a large class of hollow men. Hollow man, as competently elaborated by Craig Raine in his study of T.S. Eliot, is “a physically damaged, confined soul, corroded by its own caution, a life disfigured and distorted, rusty with reluctance”.
This phenomenon, which is present at every age, especially stands out in modern times because it stands in contrast to, and in mockery of, the slogans of free men. The commonness and its uncomfortable implications are politely hidden in a neutral word: pragmatist. The pragmatist keeps a respectful distance from established prejudices and relations, follows the consensus and never, ever rocks the boat, no matter how urgently the boat might need a shakeup.
I thought of all this as I read last Thursday that the Federal Reserve was considering imposing a 3 percent penalty on failed treasury trades.
A fail trade is a trade that a short-seller fails to deliver. I wrote about short selling in detail last year in relation with the unraveling of money markets:
The sec lending market is driven by short selling, or shorting, which is selling something you do not have. Outside the financial markets, the practice amounts to fraud; if you sell a house, or a car, or a farm you do not have, you would probably go to jail. In the financial markets, the practice is legal and very common. With the ownership requirement eliminated, the buy-sell sequence could be reversed; instead of buying first and selling later, you could sell first and buy later.In all events, the seller must deliver. Confronting him is a buyer who demands the security he just purchased. Since he himself does not have the security, the short-seller must borrow it or somehow find it in the market. When he fails to do so, in consequence of which he could not deliver the security to the buyer, we have a fail-to-deliver. It is this failure on which the Fed is imposing a 3% penalty. Here is part of the original story:
A Fed-endorsed industry recommendation will require traders to pay a three-percentage-point penalty on uncompleted trades, known as fails, starting tomorrow ... While the new recommendations are meant to curb disruptions caused when traders fail to meet their obligations, some strategists are concerned it may do more harm than good in the $7 trillion-a-day repurchase market, where dealers finance their holdings. A reduction in trading would be a setback for the Fed as it seeks to lower borrowing costs by pumping cash into the banking system and purchasing as much as $1.75 trillion in Treasuries and mortgage securities.Let us set aside all distracting technical points and focus only on the core issue: short-selling U.S. treasury securities.
Buying treasuries is lending money to the U.S. government; you get an interest bearing security from the government, the government gets your cash. Selling treasuries you own is calling back your loan. You get your money back and a new lender to the government (who bought you treasuries) replaces you and your capital.
Selling treasuries you do not have is borrowing money as U.S. government. Only the U.S. government can borrow money as the U.S. government, in the same way that only the U.S government can print money. I discussed this point in Vol. 3 of Speculative Capital:
Yet another critical point went unnoticed: how could we short a riskless bond? Shorting a bond means borrowing money. In the yin yang of borrowing and lending, risk is defined with reference to lender only. As borrowers, we face no risk; we could take the lender’s money and run. Risklessness of the US Treasuries, likewise, refers to risklessness of these securities to their buyer – those who lend to the US government. The securities are riskless because the US government would not default. It then follows that only the US government can short a riskless bond, in the same way that only the US government can print money; we, as individuals cannot. It is astounding how often the difference between buying and selling, lending and borrowing escapes the attention of the finance scholars.
The closest equivalent to shorting treasuries is counterfeiting money. Failing to deliver short is selling counterfeit money that you do not even have! Yet everyone in the market treats it as a birthright.
Imposing 3% penalty on a small part of the market – the fails – is a timid and irresolute act. It will do nothing by way of improving markets no matter how you measure it.
The correct policy action would be to warn the “market participants” that a complete ban on short selling treasuries will be implemented in a few months and then on the designated day, pull the trigger. You will be surprised how quickly and extensively the speculative element will be flushed out of the markets.
Looking around, I expect this policy to be implemented in the morning after the Judgment Day.