What is Naked Short Selling?
Naked short selling (also known as naked shorting) is the practice of selling short a stock or other tradeable security without first borrowing the shares/ asset to sell or arranging to borrow them. Short selling is used to take advantage of perceived arbitrage opportunities or to anticipate a price fall. Its greatest downside is it exposes the seller to the risk of a price rise.
When the seller does not obtain the asset and deliver it to the buyer within the agreed time frame, this is called a “failure to deliver” (FTD). In ordinary short selling, a trader who wishes to sell short a stock borrows the shares if they are pre-approved for margin trading. When the trader purchases back the shares after the anticipated price drop, they can pay back the shares they had borrowed.
Despite being made illegal after the 2008–09 financial crisis, naked shorting continues to happen because of loopholes in rules and discrepancies between paper and electronic trading systems.
Ordinary vs Naked Short Selling
To understand how naked short selling works, it’s essential to first understand ordinary short selling. When shorting a stock, a trader borrows shares of a certain stock, then sells the borrowed shares to an investor hoping the share price of the stock will fall so that they can buy the shares back on the open market at a lower price and pocket the difference. Naked short selling differs from normal short selling in that:
- The trader does not know if the security can be located and/or borrowed before the settlement day.
- The trader has no documentation to show ownership or comply with the true holder of the assets.
- The trader does not first borrow the security or make good-faith arrangements to borrow the asset in question.
Effects Of Naked Short Selling On The Market
- Some of the effects associated with naked short selling include, among others:
- Losses acquired may affect both the trader short-selling and the buyer. This may occur when the transaction has resulted in a failure to deliver. when you short a stock, its price can keep rising. That means there’s no upper limit to the amount you’d have to pay to replace the borrowed shares.
- 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.
- Dividend Payments are not awarded to Short sellers for the shares they’ve borrowed. The value of any dividends paid will be deducted from the short-sellers account on the pay date and delivered to the stock’s owner until the trader pays back the shares loaned to him/her.
- The marginal seller among existing security owners is worse off after the short sale than before since he/she can’t sell at a bit above market price after the short sale.
- If you fail to meet the margin call, your brokerage firm may close out open positions to bring your account back to the minimum requirement.
Market Regulations
Most (but not all) international exchanges have either restricted the practice or implemented server measures to safeguard the market. In August 2011, France, Italy, Spain, Belgium, and South Korea temporally banned all short selling in their financial stocks, while Germany pushed for a euro zone-wide ban on naked short selling.
- On May 18, 2010, the German Minister of Finance announced that naked short sales of euro-denominated government bonds, credit default swaps based on those bonds, and shares in Germany’s ten leading financial institutions will be prohibited. This ban went into effect that night and was set to expire on March 31, 2011.
- In March 2007, the Securities and Exchange Board of India, which disallowed short sales altogether in 2001, reintroduced shorting under regulations similar to those developed in the United States.
- Japan’s naked short-selling ban started on November 4, 2008, and was originally scheduled to run until July 2009, but was extended through October of that year.
- The Singapore Exchange started to penalize naked short sales with an interim measure in September 2008. These initial penalties started at $100 per day. In November, they announced plans to introduce new penalties that would penalize traders who fail to cover their positions.
- The U.S.A. Securities Exchange Act of 1934 stipulates a settlement period of up to two business days before a stock needs to be delivered, generally referred to as “time to deliver”.
Investor’s Note
Not all jurisdictions have banned naked shorting and some may argue that it is not necessarily harmful as it can help with determining the true value of a stock in the marketplace when the stock has low liquidity, that is if a limited number of shares are made available for borrowing to be sold short. The best advice to give in cases of naked shorting is to go forward with caution. However, if you are truly convinced that a stock price is about to drop, then shorting can be profitable as long as you stay well-informed.