What Is Naked Shorting and How Does It Work?

The financial markets offer various avenues for investors to engage with assets, primarily through buying and selling. Typically, when an individual sells an asset, they first possess ownership of that asset. This conventional approach involves transferring something already owned to another party. However, financial markets also permit strategies where assets can be sold even if they are not currently owned by the seller. Such practices facilitate diverse market activities and can influence price discovery.

Understanding Short Selling

A common strategy that diverges from traditional selling is short selling, often referred to as “covered” short selling. This method allows investors to potentially profit from an anticipated decline in a security’s price. The process begins with an investor borrowing shares of a stock from a broker. These borrowed shares are then immediately sold on the open market.

The short seller’s objective is to repurchase the same number of shares at a lower price in the future. Once bought back, these shares are returned to the lender, closing the borrowed position. The profit generated is the difference between the higher price at which the shares were initially sold and the lower price at which they were repurchased, minus any associated costs.

A fee or interest is typically paid to the broker for borrowing the shares, which can vary depending on the demand for the stock. Short selling is widely used for various purposes, including speculating on downward price movements or hedging against potential declines in other investments.

To facilitate this, brokerage firms often lend shares from their own inventory, from the margin accounts of other clients, or from other lending institutions. This mechanism allows for liquidity in the market by enabling transactions that might not otherwise occur. The requirement to borrow shares before selling ensures that there is a defined supply for the transaction.

Defining Naked Shorting

Naked shorting represents a departure from the traditional short selling process by eliminating a fundamental step. In this practice, a seller executes a short sale without first borrowing the shares or even confirming that shares can be borrowed. Unlike covered short selling, naked shorting involves selling shares that have not been located or secured for delivery. This means the seller does not possess the security at the time of the sale.

This absence of the borrowing step allows for the theoretical sale of an unlimited number of shares, potentially exceeding the actual number of shares outstanding. Such actions can artificially inflate the perceived supply of a stock in the market, which may distort its price downward. This practice is largely prohibited in the United States due to its potential for market manipulation and its capacity to create “phantom shares.”

The core distinction lies in the “locate” requirement present in covered short selling, which mandates that a seller must identify and confirm the availability of shares for borrowing before initiating a short sale. Naked shorting bypasses this crucial step, allowing sales to occur without the underlying securities being secured for timely delivery.

This can lead to a situation where the buyer’s ownership is recorded, but the corresponding shares do not materialize in the clearing system, creating an unfulfilled delivery obligation. The practice is considered illegal in the U.S. and is viewed as unethical due to its potential to disrupt fair market dynamics.

Mechanisms of Naked Shorting

Naked shorting primarily manifests through an occurrence known as a “Failure to Deliver” (FTD). In a typical stock transaction, both the buyer and seller have obligations that must be fulfilled by a specific settlement date. As of May 28, 2024, the standard settlement cycle for most stock transactions in the U.S. is T+1, meaning settlement occurs one business day after the trade date.

An FTD occurs when the seller fails to deliver the shares to the buyer by this required settlement deadline. When shares are sold without being borrowed, as in naked shorting, the seller may be unable to provide the securities on time, directly leading to an FTD. This failure to deliver can arise because the shares were never located or secured in the first place.

While FTDs can also occur for other reasons, such as technical issues or a buyer’s inability to pay, they are a direct symptom of unborrowed short sales. The transaction remains open until the asset is eventually acquired and delivered, or the seller’s broker settles the trade.

Accumulations of FTDs can indicate a significant number of shares that have been sold but not delivered, potentially due to a scarcity of available shares for borrowing. This can create a “phantom” supply of shares in the marketplace, where buyers believe they own shares that do not physically exist in the system. Such an imbalance can lead to confusion regarding a stock’s true supply and demand, potentially impacting its price. The clearing house system tracks these failures, highlighting instances where delivery obligations are not met within the stipulated timeframe.

Regulatory Responses to Naked Shorting

Regulatory bodies in the United States have implemented measures to curb naked shorting and maintain market integrity. A primary regulation addressing this is Regulation SHO (Reg SHO), introduced by the Securities and Exchange Commission (SEC). This regulation aims to reduce persistent failures to deliver and restrict activities associated with unborrowed short sales.

Reg SHO includes a “locate” requirement, which mandates that broker-dealers must have reasonable grounds to believe that a security can be borrowed and delivered on the settlement date before executing a short sale order. This provision ensures that shares are identified and secured, or at least confirmed to be available, prior to the sale.

Another significant component of Reg SHO is the “close-out” requirement, which compels firms to resolve FTDs within established timeframes. For short sale transactions, failures to deliver must generally be closed out by the beginning of regular trading hours on the settlement day following the original settlement date.

These requirements are designed to prevent the indefinite existence of undelivered shares and to ensure that all executed trades are properly settled. Additionally, Rule 10b-21, an anti-fraud provision, was adopted to target those who deceive about their intention or ability to deliver securities in time for settlement. These regulatory frameworks promote transparency in short selling activities and mitigate risks that could destabilize the market, such as the artificial depression of stock prices.