Naked short-selling

3 key takeaways

• Naked short-selling involves selling shares without actually borrowing them or ensuring they can be borrowed, creating the risk of failing to deliver the shares at the settlement date.
• It can contribute to increased market volatility and potential manipulation, as it allows sellers to exert downward pressure on a stock’s price without owning or borrowing the shares.
• Due to these risks, naked short-selling is prohibited or heavily regulated in many markets, with strict rules enforced by financial regulatory authorities to prevent abuse.

What is naked short-selling?

In traditional short-selling, an investor borrows shares from another investor, sells them on the open market, and aims to buy them back at a lower price to return to the lender, pocketing the difference as profit. Naked short-selling bypasses the borrowing step. The seller does not ensure the shares can be borrowed or delivered at the time of settlement, leading to a “fail to deliver” situation if the shares are not obtained in time.

Key characteristics

• No borrowing: Unlike conventional short-selling, naked short-selling does not involve borrowing the shares before selling them.
• Settlement risk: There is a risk of failing to deliver the shares by the settlement date, which can disrupt the market and impact investor confidence.
• Market impact: Naked short-selling can artificially increase the supply of shares in the market, exerting downward pressure on the stock price.

Risks and implications of naked short-selling

Market manipulation

Naked short-selling can be used to manipulate stock prices. By selling large quantities of shares that do not exist, sellers can create the illusion of increased supply, driving down the stock price and potentially triggering panic selling among other investors.

Increased volatility

The practice can contribute to significant market volatility. The artificial increase in the number of shares available for sale can lead to rapid and unpredictable price movements, making the market more unstable.

Settlement failures

One of the main risks of naked short-selling is the failure to deliver the shares at the time of settlement. This can cause disruptions in the clearing and settlement process, leading to potential financial losses for the parties involved and undermining market integrity.

Regulatory scrutiny

Due to its potential for abuse and market disruption, naked short-selling is subject to strict regulations. Financial regulatory authorities in many jurisdictions have implemented rules to prevent and penalize naked short-selling, ensuring fair and orderly markets.

Regulatory framework and enforcement

United States

In the United States, the Securities and Exchange Commission (SEC) has implemented rules to curb naked short-selling. Regulation SHO, adopted in 2005, requires broker-dealers to locate a source of borrowable shares before executing a short sale. It also includes a “close-out” requirement for securities with substantial “fails to deliver.”

European Union

The European Securities and Markets Authority (ESMA) oversees regulations related to short-selling in the EU. The EU’s Short Selling Regulation (SSR) imposes restrictions on naked short-selling, requiring investors to have arrangements to borrow the shares before selling them short.

Other jurisdictions

Many other countries have similar regulations to prevent naked short-selling and ensure market stability. These regulations typically involve requirements for locating and borrowing shares before short-selling and penalties for non-compliance.

Example of naked short-selling

Case study: Overstock.com

In the mid-2000s, Overstock.com, an online retailer, was a prominent example of the impact of naked short-selling. The company claimed that naked short-sellers had manipulated its stock price downward by selling shares that did not exist. Overstock.com sued several broker-dealers and financial institutions, leading to increased scrutiny of the practice and regulatory action to curb naked short-selling.

How to identify and avoid naked short-selling

Due diligence

Investors should conduct thorough due diligence before engaging in short-selling. Ensuring that shares can be borrowed and understanding the risks involved in short-selling are crucial steps in avoiding naked short-selling.

Working with reputable brokers

Choosing a reputable broker-dealer who complies with regulatory requirements can help investors avoid the pitfalls of naked short-selling. Reputable brokers will have systems in place to ensure shares are located and borrowed before executing short sales.

Understanding regulations

Staying informed about the regulations governing short-selling in the relevant jurisdiction is essential. Investors should be aware of the rules and penalties associated with naked short-selling and ensure their trading practices comply with these regulations.

Related Topics:

• Short-selling
• Securities lending
• Market manipulation
• Regulation SHO
• Financial regulation

Exploring these topics will provide a deeper understanding of the mechanisms, risks, and regulations associated with naked short-selling and how it impacts market dynamics and investor behavior.