Do You Understand What "Naked Short Selling" Is?

"Naked Short Selling" is the term used for the practice of selling shares of a stock short, without the shares determined to exist to borrow prior to the transaction being executed.

This process is covered by US Securities and Exchange Commission regulations and is said to have been abused widely in the financial markets.

The SEC regulations covering this are the "Securities Exchange Act of 1934" and the more recent "Regulation SHO".

For further information regarding shorting stocks, read about the following topics also on this website:

• Introduction to Short Selling
• Steps to Take Short Selling Stocks
• Shorting Stocks: Examples
• The Uptick Rule

Short Selling Review

The process of short selling is to place an order to sell shares of a stock first, and buy them back later, or "cover your position". This is the opposite of when you buy the shares first and sell them at a later time.

When you place the order to sell the shares short, the broker executes the trade, while at the same time the broker borrows the number of shares that you sold short. This is done to make sure the shares are available for you to buy back, or cover, at a later date.

What Actually Occurs

Normally, when you place an order to sell shares of a stock short, the broker, or brokerage firm, is allowed to let the trade occur as long as they have a belief that the shares are, or will be, available shortly to borrow.

In the often fast moving markets that we have today, trades get executed so fast that often short selling occurs without there being enough time to borrow the shares first.

When this occurs, it is called "Naked Short selling".

Abuse of Naked Short Selling occurs when the short sale is executed without any regard to the shares actually being available to buy back.

It is, or has been a widespread function in the markets. This process of allowing the short sale to occur without regard to the availability of the shares to borrow is illegal, but hard to enforce.

After all, from my understanding as the regulations are worded, how could you prove that the broker, or brokerage firm didn't check or wasn't sure if the shares were available to borrow?

Arguments For And Against

Critics against Naked Short Selling argue that the abuse is widespread and have caused billions of dollars in lost asset valuations.

They state that the practice is being abused by allowing prices to be manipulated to drive down prices for the benefit of causing a panic sale, allowing for shares to be purchased later at a lower price.

Arguments for are that the process adds liquidity to the markets by allowing shares to be exchanged more freely.

Outlook

The problems with Naked Short Selling, as with anything else, are the one's who abuse it. The SEC has made it clear that they have a zero tolerance for anyone abusing this process.

With the crisis hitting the financial markets recently, I can easily see that there will be more investigations and litigation to come real soon.

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