Differences between Naked Short Selling and Short Selling
Contents
Comparison Article[edit]
Short selling is a financial practice where an investor sells a security they do not currently own, intending to purchase it back later at a lower price. This process typically requires the seller to borrow the shares from a broker-dealer or a central lending pool. In contrast, naked short selling occurs when a trader sells a security without first borrowing the shares or ensuring that the shares can be borrowed. This practice often leads to a failure to deliver the shares to the buyer within the standard settlement timeframe.
Short selling vs. naked short selling[edit]
Standard short selling is a regulated activity in most global financial markets. It provides liquidity and allows for price discovery by enabling investors to express a bearish outlook on a specific asset.[1] To execute a legal short sale in the United States, the seller must comply with Regulation SHO, which includes a "locate" requirement. This mandate requires brokers to have reasonable grounds to believe that the security can be borrowed and delivered on the settlement date.
Naked short selling bypasses the borrowing requirement. This can result in the creation of "phantom shares," where the number of shares sold exceeds the actual float of the company. Because there is no check on the availability of shares, naked shorting can be used to exert downward pressure on a stock price in a manner that traditional shorting cannot. The Securities and Exchange Commission (SEC) banned most forms of naked short selling following the 2008 financial crisis to prevent market manipulation.[2]
Comparison table[edit]
| Category | Short selling | Naked short selling |
|---|---|---|
| Borrowing requirement | Must borrow shares before the sale | No shares are borrowed |
| Legality (U.S.) | Legal and regulated under Reg SHO | Generally illegal since 2008 |
| Settlement | Shares delivered on T+1 cycle | Results in "failures to deliver" (FTDs) |
| Market impact | Increases liquidity and price efficiency | Can artificially depress stock prices |
| Share supply | Limited by the available loan pool | Potentially infinite (phantom shares) |
| Broker role | Must "locate" shares for the client | Executes trade without locating shares |
| Risk level | High (unlimited potential for loss) | Extremely high (legal and systemic risk) |
Regulatory framework[edit]
The primary regulation governing these practices in the United States is Regulation SHO, which became effective in 2005. Rule 203(b)(1) of this regulation prohibits a broker-dealer from accepting a short sale order unless it has borrowed the security or entered into a bona fide arrangement to borrow it.[3]
When a naked short sale occurs, it typically results in a "failure to deliver" (FTD). This means the seller's brokerage firm does not give the shares to the buyer's brokerage firm by the settlement date, which is currently T+1 in the U.S. markets. Persistent FTDs in a specific security are tracked on the "Threshold Securities" list. If a stock remains on this list for thirteen consecutive settlement days, brokers are required to close out the failure positions by purchasing shares in the open market.[4]
References[edit]
- ↑ Securities and Exchange Commission. "Key Points About Regulation SHO." SEC.gov. 2015.
- ↑ Financial Industry Regulatory Authority. "Short Sale FAQ." FINRA.org. 2023.
- ↑ Investopedia. "Naked Shorting: Definition, Examples, and Legality." Investopedia.com. 2024.
- ↑ U.S. Securities and Exchange Commission. "Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO." SEC.gov. 2024.
