Naked short selling is the practice of selling shares that have not been borrowed or even located, a significant departure from standard short selling procedures.
Understanding Naked Short Selling
In traditional short selling, an investor borrows shares from a broker and then sells them, hoping to buy them back later at a lower price to return to the lender and profit from the difference. However, naked short selling bypasses this crucial first step. It involves selling shares that the seller does not own, has not borrowed, and has not confirmed the ability to borrow. This effectively creates "phantom shares" in the market, as the sale occurs without an underlying asset to deliver.
How Does It Differ from Regular Short Selling?
The fundamental difference lies in the pre-borrow requirement:
| Feature | Regular Short Selling | Naked Short Selling |
|---|---|---|
| Share Location | Shares are located and borrowed before the sale. | Shares are not located or borrowed before sale. |
| Ownership | Seller temporarily borrows and then sells existing shares. | Seller sells shares they don't own or have access to. |
| Legality | Legal and regulated. | Illegal in most jurisdictions. |
| Delivery Risk | Low, as shares are pre-borrowed for delivery. | High, leading to potential Failure to Deliver (FTD). |
Why is Naked Short Selling Illegal?
Naked short selling is illegal because it can severely disrupt market integrity and fairness. The primary regulation targeting this practice in the United States is Regulation SHO, introduced by the U.S. Securities and Exchange Commission (SEC).
- Phantom Shares: By selling shares that don't exist, naked short sellers can flood the market with "phantom" supply, artificially driving down a stock's price, often without any fundamental reason.
- Market Manipulation: This artificial pressure can be used to manipulate stock prices, particularly for smaller or less liquid companies, leading to significant losses for legitimate long investors.
- Settlement Failures: A direct consequence of naked short selling is a "failure to deliver" (FTD). This occurs when the seller cannot deliver the shares to the buyer by the settlement date (typically two business days after the trade, or T+2), because they never actually borrowed them.
Consequences of Naked Short Selling
The repercussions of engaging in illegal naked short selling can be severe:
- Legal Penalties: Firms and individuals found guilty of naked short selling can face substantial fines, trading suspensions, and even criminal charges from regulatory bodies like the SEC.
- Market Instability: Widespread naked short selling can undermine investor confidence and create instability in the financial markets.
- Damage to Companies: Companies targeted by naked short sellers can suffer severe reputational damage and see their stock prices plummet, potentially leading to financial distress or bankruptcy, even if their underlying business is sound.
Regulatory Efforts and Protections
Regulation SHO, implemented in phases since 2005, introduced specific rules to combat naked short selling, including:
- Locate Requirement: Brokers must confirm that shares can be borrowed before executing a short sale.
- Close-Out Requirement: If a firm fails to deliver shares on a short sale, they must take action to close out the position by purchasing the shares within a specified timeframe.
- Pre-Borrowing for Certain Securities: For specific "threshold securities" (those with persistent FTDs), stricter pre-borrowing rules apply.
These measures aim to ensure that short sales are executed only when legitimate shares are available for delivery, protecting market participants from manipulative practices and systemic risks.
