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A naked short sale, (or naked shorting), is the illegal form and practice of selling shares or securities short. It is considered as a device to depress stock prices.

The practice is relatively new to the capital markets. It is when Short selling takes place on a security, but instead of borrowing a share before selling it, the seller does not borrow or arrange to borrow the securities in time for settlement (in the major United States capital markets, settlement typically takes place three days after the transaction). A seller sells something that he doesn't own, and the buyer pays his money, receiving nothing in return but a brokerage statement representing an IOU for the shares ordered. As a result, the seller fails to deliver securities to the buyer when delivery is due; this is known in the securities industry as a "failure to deliver".

Controversy

Naked short selling can threaten the stability of stock prices because stocks can be sold without having to first acquire them from existing owners. In practice, true naked shorts cannot be maintained by public investors since they must either have the shares borrowed for them by their brokers in advance or promptly deliver the physical shares. Therefore, true naked shorts are typically done by broker-dealers and market makers who are able to maintain such naked short positions in secrecy via simple electronic journaling or book-keeping, intra-firm, to customers who bought and who simply need to see share figures on their statements to feel assured. Although this is illegal as the stated share ownership is bogus, it can be extremely difficult to detect, unless the buyer requests physical delivery of share certificates, which is very rare these days. Even where such delivery is sought, the broker-dealer or market maker can always buy the needed shares on the open market, and deliver those, in the rare event delivery is sought.

In the United States, the Securities and Exchange Commission enacted Regulation SHO to prohibit Naked Short Selling. However, Regulation SHO makes an exception for market makers engaged in "bona fide market making". Market makers do not have to locate stock before selling short, because under certain circumstances they need to be able to provide liquidity. Regulation SHO also put in place a warning system against the risk of stock price instability by publicly identifying securities where short positions composed more than 10,000 shares and more than 0.5% of the Total Shares Outstanding for 5 consecutive settlement days or more.

Even after the enactment of Regulation SHO, naked short sales have again come under scrutiny due to the large number of stocks which have triggered the warning system.

Criticism

Critics believe that Naked short selling causes an unnatural depression in share price by artificially and bogusly boosting the supply of shares available to the market. This results in a market inefficiency, as unlimited supply meeting fixed demand equates to price depression. Illegal naked short selling is a market manipulation tactic, and is really nothing more than fraud. The product remains undelivered, but the buyer is never notified that he hasn't received his share. In fact, naked shorters will not want the buyer to know that the shares came from thin air, and the number of shares shown on the confirmation and monthly statements is pure fiction. Meantime, the naked shorter gets to use the buyers' purchase money and to earn interest on it at low risk. Since naked shorters are typically able to create virtually unlimited artificial supply to drive share prices lower and to later buy them back (cover), substantial profits are made in such operations.

Companies are adversely affected when they need to do secondary offerings of stock to fund their growth or operations, and the price is artificially low. Investors are adversely affected when their stock is depressed, and if sold, sold for an artificially low price. Naked short selling as a trading strategy has been illegal since the creation of the SEC in 1934, but is still going strong because by its very nature, and especially today with electronic book-keeping being the norm, it is extremely difficult to detect without the self-incriminating confessions from the naked short sellers themselves.

Counter criticism

In 2003, the SEC implemented a new rule to ban the practice. The ruling was mainly to protect vulnerable stocks to aggressive short-selling. However, oppononents of this rule have been arguing that "if naked-shorting had not taken place during the micro-cap crime wave of the 1990s, such stocks would have climbed even higher before they crashed".

But this argument in favor of naked short selling is specious and without merit, except to preserve the special privilege and unfair advantage of broker-dealers and market makers over the public. The truth is that most stocks move higher because the public are induced to buy more as a result of "recommendations" and "upgrades" from Wall Street analysts who routinely give higher and higher price targets to fuel the speculation on stocks their firms and clients have already bought at low prices and waiting to unload. Secondly, naked shorts are typically done at or near price exhaustion, since broker-dealers and market makers are extremely shrewed at avoiding risk and almost invariably make huge profits from such operations. Thirdly, Wall Street's "downgrades" are extremely powerful and are additionally and routinely used to drive stock prices down that they have already sold short naked. Fourthly, there are better and fairer solutions such as allowing no margin purchase or margin short sale of such micro-caps, to stem speculative excesses.

See also

• Bear market
• Behavioral finance
• Free ride
• Long / short equity
• Share price
• Short selling
• Stock market bubble

External links

• A short selling tutorial at Investopedia
• Who's behind Naked-shorting? - Fool.com
• A FAQ by DTCC First Deputy General Counsel Larry Thompson

• Stock market
• Finance
• Financial markets