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A naked short sale is when Short selling takes place on a security, but the seller does not borrow or arrange to borrow the securities in time for Settlement (finance) (in the major United States capital markets, settlement typically takes place 3 days after the transaction). 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".
Naked short selling can threaten the stability of stock prices because stocks can be sold without having to first aquire them from existing owners.
In the United States, the Securities and Exchange Commission enacted Regulation SHO to prohibit Naked Short Selling. Howver, 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.
Advantages for the market of naked short selling
In criminal stock fraud operations, retail investors are encouraged by either a stock promoter or bucket shop to buy a stock pushing it's value far beyond its true value. This is also called pump and dump. If naked shorting were allowed by SEC rules, other brokerages would step in and naked short the stock bringing it back to true value. In essence, SEC rules against naked shorting allows criminal stock fraud operations to exist and make large profits. By making naked shorts illegal, volume of trading is reduced resulting in higher spreads and illiquidity. Also, present naked shorting rules allow brokerages to make large profits doing "bona-fide market making" while stock markets are falling. Since retail investors are not allowed to do naked shorting, this presents an unfairness or uneven playing field.
Disadvantages for the market of naked short selling
Naked Short Selling causes a unnatural drop in share price by artificially boosting the supply of shares available to the market. This reduces market efficiency. Companies who are doing a stock offering will have to issue more shares to raise the same amount of cash. Also, present naked shorting rules allow brokerages to make large profits doing "bona-fide market making" while stock markets are falling. Since retail investors are not allowed to do naked shorting, this presents an unfairness or uneven playing field.