Naked Short Selling: What It Is & How It Works

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What Is Naked Short Selling?

Naked short selling, or naked shorting, is the process of selling shares of an investment security that have not been confirmed to exist. In contrast, conventional short selling begins with an investor borrowing shares. Naked shorting is done without having first borrowed the shares, hence the “naked” moniker.

Important: Naked short selling is not legal. A seller of a security is required to deliver shares of the security to a buyer promptly at settlement. Since naked shorting involves the selling of shares that do not exist, or have not been borrowed, a scenario is made possible where the seller fails to deliver the equity security to the buyer at settlement. Put simply, if shares are not available to “cover” a short sale, the short position is said to be naked.

How Naked Short Selling Works

To understand how naked short selling works, it’s important to first understand the normal practice of short selling. When shorting a stock, an investor borrows shares of the stock from a broker, then sells the borrowed shares to another investor. Expecting the share price of the stock to fall, the investor buys the shares back on the open market at a lower price, then delivers them to the original owner, pocketing the difference as profit.

Naked short selling differs from normal short selling because naked shorting involves the selling of shares without having first borrowed the shares. Thus, the naked short seller is selling shares they do not own, and shares that aren’t confirmed to even exist. If the seller is required to close their position, there are no borrowed shares to return to the original owner. This may result in the failure to deliver the shares.

Naked Short Selling Regulations

Short selling is regulated by the Security Exchange Commission (SEC), which was given this authority under Section 10(a) of the Securities Exchange Act of 1934. The SEC’s primary objective is to protect the interests of investors. It’s this objective that led the SEC to ban the practice of naked short selling in the U.S. after the financial crisis of 2008.

As explained in Regulation SHO, naked shorting creates a risk of “fails to deliver” (FTD). This is because naked short selling is done without first borrowing shares. Thus, if a naked short seller is required to cover or close out their position, and shares are not available, the seller will fail to deliver the shares to the buyer.

The Commission’s concern is that persistent and large-scale failures to deliver can deprive shareholders of their rights of ownership, such as voting. Furthermore, an FTD on the settlement date may create an additional risk of stock price manipulation, which occurred on a wide scale during the financial crisis of 2008.

Market Impact of Naked Short Selling

As is the case with any controversial form of trading, there are varying opinions about the market impact of naked short selling. A proponent of naked short selling might argue that it can provide efficiency in the market by allowing negative sentiment to the positive sentiment of the long positions.

An opponent of naked short selling, which is the position of the SEC, would argue that naked short selling can artificially drive a stock’s price down and impact a stock’s liquidity. This is because an unchecked ability to sell shares short, without the possibility of delivering the shares, introduces price manipulation and artificially increases a stock’s liquidity.

Naked Short Selling Example

A recent example of naked short selling is a case brought by the SEC against a broker-dealer. The broker repeatedly violated Regulation SHO, which requires brokers to mark all sell orders for stocks as either “long,” “short” or “short exempt.”

BTIG marked $250 million of short sale orders of a hedge fund as either “long” or “short exempt.” However, a sell order can only be marked long if the security is owned or is “reasonably expected” to own the shares at the time of settlement. However, with naked shorting, the short seller cannot take possession of shares they don’t own or that have not been borrowed.

In essence, the shares of the hedge fund’s short sales did not exist, as they could not provide evidence that they owned the securities on the trade date. The broker enabled shares that failed to deliver. This is a risk and problem of naked short selling: a naked short seller cannot deliver shares of a security that do not exist.

Bottom Line

While short selling is legal, naked short selling is not. The reason for this is that naked shorting involves the shorting of shares that do not exist, which is a practice that has been banned by the SEC. Naked shorting contrasts with normal short trading, where the short seller borrows shares with the intention of returning them at a later date.

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