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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 acquire them from existing owners.
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.
Disadvantages for the market of naked short selling
Naked Short Selling causes an unnatural depression in share price by artificially 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 - 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 a share. The product remains undelivered, but the buyer is never notified that he hasn't received his share.
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.