Naked shorting, the practice of selling short shares that have not been affirmatively determined to exist, has garnered significant attention in the financial world. Despite being made illegal after the 2008–09 financial crisis, naked shorting continues to occur due to loopholes in regulations and discrepancies between paper and electronic trading systems. In this article, we will delve into the concept of naked shorting, explore its impact on the market, discuss relevant regulations, and examine the ongoing debate surrounding its potential benefits and risks.

Understanding Naked Shorting

Naked shorting involves selling shorts associated with shares that investors do not possess and have not confirmed their ability to possess. Unlike regular short selling, where traders borrow or locate the stock before selling it short, naked shorting occurs without ensuring the availability of the shares. This practice carries a high level of risk but also has the potential for significant rewards.

One way to identify naked shorting is by examining trades that fail to deliver from the seller to the buyer within the mandatory stock settlement period. Many market systems consider these failed trades as evidence of naked shorting, with naked shorts accounting for a significant portion of such instances.

The Impact of Naked Shorting

Naked shorting can have implications for the liquidity of a particular security in the market. By allowing participants to engage in short selling even without access to the shares, it provides a means for investors to participate in the market despite the unavailability of the stock. Increased demand resulting from additional investors interested in shorting a particular security can contribute to improved liquidity in the marketplace.

Regulations Regarding Naked Shorting

Recognizing the risks associated with naked shorting, the Securities and Exchange Commission (SEC) banned this practice in the United States in 2008, following the financial crisis. It is important to note that the ban specifically targets naked shorting, while other forms of short-selling activities remain permissible. In 2007, the SEC also amended Regulation SHO to address the issue of naked shorting by closing existing loopholes for brokers and dealers. Regulation SHO requires the publication of lists tracking stocks with unusually high trends in failing to deliver (FTD) shares.

Naked Shorting as a Market Function

Some analysts argue that naked shorting, controversial as it may be, can inadvertently contribute to market balance by allowing negative sentiment to be reflected in stock prices. In cases where a stock has limited availability and a significant number of shares held by long-term investors, market signals may be delayed. Naked shorting can force a price drop, even without available shares, leading to the unloading of actual shares to minimize losses and allowing the market to find equilibrium.

Examples of Naked Shorting

Instances of naked shorting leading to legal action have been observed. In 2014, two professors from Florida State University were charged with using naked short selling in over 20 companies, resulting in significant revenue. The cannabis sector also faced speculation about widespread naked shorting in 2018, with short interest growing despite limited availability of shares.

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