Settling a trade

Every stock market in the world has procedures for how a trade is settled, that is, where and when the buyer brings his cash, the seller his stock and the two complete the bargain entered into when the trade was agreed to.   In the case of the US, this usually occurs three days after the bargain is struck.

Curing a failed trade

Every stock market also has standard procedures to deal with a trade that “fails,” that is, cases where the deal isn’t completed, because one party or the other doesn’t show up or brings the wrong amount of money or the wrong amount of stock.

Penalty fees may be involved.  And, if the seller can’t deliver the stock he has promised to the buyer after a reasonable (but short) amount of time, the broker typically is authorized (and legally required) to buy the agreed-upon shares in the open market, deliver them to the buyer from the original trade, and send a bill to the seller.

“naked” shorts

This brings us to “naked” short sellers.   Before the short seller enters his “sell” order, he is supposed to have good reason to believe he can deliver the required stock on settlement day.   As I mentioned in my first post on short selling, there is an elaborate infrastructure in the US devoted to stock lending, the process of making stocks available for short sellers to borrow.  So the short seller should have a very good idea whether borrowing a given stock is possible or not, and how long it will take to get the stock into his hands.

A short seller who pretty much knows he can’t borrow a given stock, or has no intention of borrowing the stock, but sells it short anyway is called a “naked” short seller. Generally speaking, except for market makers providing temporary liquidity to a market, the practice is illegal. Until the past few years the rules weren’t enforced, so naked shorting occurred anyway.  In the best of circumstances, the buyer ended up being an uncompensated lender to the short seller, who was avoiding posting collateral and paying fees to a stock lender.  At worst, the short seller was trying to manipulate the market in a given stock.

market makers vs. hedge funds

I think it’s important to distinguish here between the activities of market makers in a given stock and those of professional investment managers, like hedge fund operators, who may sell a variety of stocks short.  Both may be “naked” short sellers.  But their activities are very different.

A market maker who sees an imbalance of buyers over sellers in one of his stocks may provide liquidity to the market by shorting shares to buyers.  His intention is to buy the shares back quickly himself to reestablish a neutral position, not to borrow the stock from a third party (and pay fees).  Clearly, the market maker intends to make money from his shorting activity, but one can reasonably argue that his actions have a stabilizing function.

This is very different, I think, from the actions of a professional investment manager, who from the outset doesn’t intend to honor the bargain he makes with a buyer.  He depends instead on the rules against naked shorting not being enforced so that he can evade his contractual obligation for as long as possible.

His actions are basically destabilizing, since he is overriding one of the basic safety features of any market that allows short selling–the requirement that you can only sell stock you have an ownership right to.

Why is this distinction important?–because advocates of naked shorting seem to me to deliberately muddy the waters by citing the benefits of shorting by market makers as a defense for the destabilizing actions of some professional money managers.

What’s wrong with naked shorting, in my opinion

1.  The regulatory requirement that a short seller be able to settle his trades is a reasonable one.

–It ensures that the buyer is able to profit if his “buy” decision is correct, instead of winding up with a failed trade and a stock that has run away from him.

–It also eliminates the possibility of bogus transactions by short sellers who can’t borrow stock, or who don’t want to post collateral or pay fees, yet who want to defend their short positions by impeding the upward movement of the stock.

2.  The need to borrow shares sets a natural limit (the number of shares outstanding) on how how many shares of a company’s stock can be shorted.  In practice, the limit to shorting is actually lower–the number of shares that holders are willing to lend.  The ability to create phantom shares through naked shorting tilts the playing field sharply in favor of short sellers.

3.  From a tactical point of view, holders of a stock have two defenses against short sellers, both of which are neutralized by naked shorting.  They are:

–Owners can call back the stock their organizations have lent to short sellers, forcing the latter either to find shares to borrow elsewhere or go into the market and “cover” (buy back the stock) their short positions.  Or,

–holders themselves can enter the market as buyers and try to support the current price by absorbing all the stock for sale, and potentially drive the price higher.

Either tactic can create a “short squeeze,” that is, a self-perpetuating scramble of short sellers to cover their short positions that, like a snowball rolling downhill, pushed the stock price considerably higher.  However, naked shorting removes these risk elements for short sellers.

You can’t call back stock that has never been lent and exists only in the imaginations of the short seller and his broker.  You also can’t dry up  the pool of sellers if they can “manufacture” new stock to short out of thin air.

A problem until 2005

That’s when the SEC instituted Regulation SHO, which makes brokers to follow rules that were already on the books.  In particular, it requires brokers to:

–document that borrowed stock is available to settle a trade before the bargain is struck, and

–“close out” a trade that has failed for 13 consecutive trading days by buying in the securities and delivering them to the original buyer.  The close out rule only applies, however, to stocks that exceed specified levels of failed trades.

In the link to the SEC website above, the agency is at great pains to point out that it does not regulate “pink sheet” stocks, seemingly implying that naked shorting is common there, even today.

There’s also academic research demonstrating that manipulative naked shorting was prevalent until Regulation SHO, after which it has substantially disappeared.  Oddly enough, I first became aware of this paper by reading commentary in Barron’s that made fun of SEC concern about naked shorting of Bear Stearns and Lehman (the paper concludes there wasn’t any–thanks to Regulation SHO).

Why is this important now?

The SEC is reviewing its short selling regulations.  It has just reinstated a modified uptick rule and proposes looking at naked shorting next.  There’s bound to be brokerage industry argument that Regulation SHO isn’t needed because naked shorting wasn’t a factor in the collapse of financial stocks in 2008.  But that’s just not true.