If Naked Short Selling Is Illegal, How Is It Still Being Done?
The mere name makes it sound scandalous, and indeed it has become so: naked short selling. But what exactly does it mean? Is it legal? And if it isn’t, is it still being done and if so, how?
Let’s turn to the experts, as this is a rather complicated subject to break down.
Understanding Naked Short Selling
“Naked short selling is a trading practice in which shares are sold without first being borrowed or otherwise determined to exist,” said Harry Turner, founder of The Sovereign Investor. “The practice involves investors betting on the price of a security falling by selling shares that do not actually exist, generating artificial sell pressure and potentially allowing them to profit from the downtrend.”
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Note that naked short selling differs from normal short selling.
“Normal short selling [is] where the seller first borrows shares, then sells them,” said June Jia, owner of Canny Trading and a quantitative researcher. “In typical short selling, the borrowed shares are eventually returned to the lender, whereas in naked short selling, no shares are actually borrowed or delivered, which creates ‘phantom shares.'”
The History of Naked Short Selling
Naked short selling has been around for centuries, but it gained steam — and notoriety — in the early 2000s following extreme losses incurred by droves of investors that sparked an investigation by the Securities and Exchange Commission (SEC).
“It was found by regulators to be highly detrimental to the securities market because it allowed traders to artificially drive down prices for their own gain through false rumors or negative publicity,” Turner said. “The concern was that this could lead to large losses for legitimate investors who held long positions due to an increased number of false sales.”
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted. This contains strict provisions meant to prevent naked short selling, “including a ban on ‘naked access,’ where brokers allow customers direct access without pre-approving each trade,” Turner said.
“It also includes rules requiring investors to place orders through a clearing agency before executing transactions outside standard settlement times, as well as activities such as fail-to-deliver deadlines, public notification procedures and rebate requirements on certain transactions.”
Naked Short Selling Is Technically Illegal — But It Still Happens
Though the SEC made naked short selling illegal in 2008, instances of naked short selling have occurred in the U.S since. One famous example happened fairly recently, with GameStop shares.
“The most infamous recent example of naked short selling was the GameStop saga in 2021, where traders reportedly sold short around 140% of its shares,” Turner said. “This meant that 40% more shares were sold short than existed, which is only possible with ‘phantom’ sales from naked short selling.”
What this means, essentially, is that naked short sellers deposited digital entitlements into buyers’ accounts, “which are like a promise or IOU to locate the actual shares and deliver them at some point,” Turner explained.
“However, when the short squeeze picked up steam, the lack of available shares meant that many short sellers failed to deliver these borrowed shares. This led to a parabolic rise in the share price and many trades not getting settled.”
Naked Short Selling Continues Via Loopholes
Naked short selling continues today, albeit on a much smaller scale than it did prior to 2008. Though technically illegal, the practice is able to be executed through numerous loopholes, including zero-plus agreements.
“One way that traders have been able to circumvent laws and regulations against naked short selling is by entering into ‘zero-plus’ agreements, which allow them to simultaneously enter into long and short trades,” Turner said. “This means they can offset any potential losses from naked shorting while avoiding penalties from regulators.”
Another loophole traders can exploit is called “payment for order flow.” In this scenario, brokers “receive payment for routing orders away from exchanges and into dark pools, allowing them to bypass certain rules or restrictions on their trades,” Turner explained.
“This can make it more difficult for regulators to detect cases of illegal naked shorting since trades are routed away from exchanges, thus making the transactions more difficult to trace.”
Yet another fast one traders can pull is to employ multiple entities (e.g., offshore accounts) that disguise their activities so as to not raise suspicion from regulatory agencies.
“For example,” Turner said, “if an entity enters into a complex network of contracts spread out over several countries, investigators will likely have difficulty tracing back all the interlinked accounts involved in a single transaction.”
Naked short selling, when carried out, however deviously, is a generally negative occurrence that can upset and confuse the market.
“Naked short selling can lead to a vicious cycle in which short sellers drive down the stock price, triggering more short selling and further pushing down the price,” Jia said. “This can cause panic among investors.”
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