Naked Shorting Explained: Risks, Regulations & US Restrictions

Naked shorting is the practice of selling short a stock or other tradeable security without first borrowing the shares to sell or arranging to borrow them. Naked shorting is not illegal in every jurisdiction, but it is prohibited in the United States.

Summary

• Naked shorting is the practice of short selling a stock or other security without borrowing, or arranging to borrow, the shares to sell short from one’s broker.
• The practice of naked shorting is prohibited in the United States but not in all trading jurisdictions.
• The banning of naked short selling is not universally approved. Some market analysts believe that naked shorting can be a valuable market practice that helps to accurately determine the true value of a security.

Naked Shorting vs. Ordinary Short Selling

In ordinary short selling, a trader who wishes to sell short a stock borrows the shares he or she wishes to sell short from their broker. To borrow shares, the trader must be pre-approved for margin tradingMargin TradingMargin trading is the act of borrowing funds from a broker with the aim of investing in financial securities. The purchased stock serves as collateral for the loan. The primary reason behind borrowing money is to gain more capital to invest. When the trader closes out their short sale by purchasing an equivalent number of shares in the open market, they then use the purchased shares to pay back the loan of shares to sell from their broker.

In naked shorting, the trader has not borrowed or arranged to borrow from their broker shares to sell short. Therefore, when they make a short sale, they are basically selling something that they don’t have. It results in a “failure to deliver” the shares to the buyer.

When a short sale of stock occurs, the shares sold must be delivered to the buyer within three business days. Otherwise, a failure to deliver results, and the transaction is canceled. A trader who engages in naked shorting hopes to close out their short sale at a profit before the expiration of the required three-day settlement time frame.

Practical Example

Trader A sells short 100 shares of Stock XYZ, even though he has not been approved for margin trading and, therefore, cannot borrow the shares to sell from his broker. He hopes for a quick decline in the price of the stock so that he can close out his short sale with a purchase of 100 shares at a lower market price before the three-day time limit to deliver the shares he sold short is up.

The trader is, essentially, looking to square out his trading position before it is discovered that he has sold short shares that he did not actually possess to sell.

Regulations

Naked short selling was prohibited by the Securities and Exchange Commission (SEC)Securities and Exchange Commission (SEC)The US Securities and Exchange Commission, or SEC, is an independent agency of the US federal government that is responsible for implementing federal securities laws and proposing securities rules. It is also in charge of maintaining the securities industry and stock and options exchanges in the United States following the 2008 Global Financial Crisis. The ban was, in part, a response to the belief that naked shorting had contributed to the collapse of Lehman Brothers, which was a major catalyst for the ensuing market crash and financial crisis.

Before banning naked shorting outright, the SEC initially sought to limit the practice through Regulation SHO. However, the regulation, which required the listing of stock with high levels of failure to deliver transactions, was eventually found to be largely ineffective in preventing naked short selling.

There is widespread disagreement as to how effective the SEC’s ban on the practice has been, with many arguing that the SEC’s rules concerning short selling are both ineffective and often not enforced.

The Argument in Favor of Naked Shorting

Some market analysts and participants have argued against the ban on naked short selling. Their argument is that naked shorting can serve a purpose in determining the true value of a stock in the marketplace when the stock has low liquidity and, therefore, a limited number of shares available that can be borrowed from a broker and sold short. In such a situation, naked short selling may drive prices down to a level it more accurately reflects the stock’s true value.

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