“In an abusive naked short transaction, the seller doesn’t actually borrow the stock, and fails to deliver it to the buyer. For this reason, naked shorting can allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions.”
– “What the SEC Really Did on Short Selling”, by Christopher Cox (SEC Chairman), Wall Street Journal, July 24 2008, P. A15.
The last month has seen much gnashing of congressional and regulatory teeth over the matter of market prices: Oil is too expensive and certain financial stocks are too cheap. As you might expect, buying (of oil futures) and selling (of the financial stocks) are the deemed culprits. To try to make stock prices rise, the SEC has enacted temporary regulations altering the rules governing short sales for 19 financial stocks, tightening the requirement that short-sellers locate shares before they can sell. Is Christopher Cox right that naked shorting is a serious problem?
A naked short (I will resist the urge to make jokes) occurs when a trader sells stock without delivering shares to the buyer. This may sound to you like something can’t happen—- how can a sale occur when there are no shares to sell? A naked short cannot occur by itself: There must be a naked buy to accompany a naked sell. If a seller fails to deliver shares, the buyer fails to receive a share. If naked shorting drives the price down, shouldn’t naked buying drive it up?
Naked shorting sounds ominous, but when you dissect a naked short, it is basically the same as a single-stock futures transaction: Two traders make a bet on the share price and every day the winner pays the loser. A single stock futures market exists, so naked shorting doesn’t offer anything fundamentally different from what is already available to traders. This should be no surprise: In modern financial markets there are usually multiple ways to achieve the same economic result. Investors will choose the least costly means of achieving an end. Both a futures contract and a naked short are bets on the share price. In neither case are actual physical shares involved (at least until a futures contract matures), and in both cases, for every seller there is a buyer. The derivatives exchanges—- which offer an officially approved way to engage in naked shorting—- are probably thrilled with the SEC.
The logistics of a naked short are interesting if you’re curious about the details of securities transactions. An informative paper on naked shorting, from which I learned a lot, is Leslie Boni’s paper “Strategic Delivery Failures in U.S. Equity Markets”, Journal of Financial Markets 9, 2006, 1-26. Boni documents the extent of naked shorting looking at data from 2004 and before.
How does a naked short actually work? Buyers and sellers typically transact using brokers. In a typical stock transaction, within three days the buyer has to deliver payment for shares and the seller has to deliver the shares. The share transfer is usually done by book entry in the broker’s account at the National Securities Clearing Corporation (NSCC), rather than by delivering actual physical shares. The NSCC typically does not know the identity of the buyer and seller, only the identity of their brokers. The broker in turn keeps track of which customers are entitled to the shares. A short-sale is similar, except that the short-seller is supposed to first borrow shares in order to be able to deliver them to the buyer.
Brokers can lend shares to short-sellers. Share-lending does not affect the number of the broker’s customers who own shares, but the broker will have fewer shares than there are customer positions. For example, a broker may have customers who own 100,000 shares of IBM. If the broker lends 60,000 shares, the broker possesses only 40,000 shares, but the customers still have an economic position in 100,000 shares. This is important for understanding naked shorting: Even under normal circumstances, your broker may not have possession of the shares that you bought. We will return to this point in a moment.
If the seller does not have shares to deliver, the result is a “failure to deliver” (a “fail”). If there is a fail, there are at least three possibilities: the transaction can be rescinded; the buyer can try to force delivery; or the fail can persist. The SEC doesn’t like persistent fails, but a fail can persist because the buyer and seller mark their positions to market every day. If the stock rises $5, the seller’s broker will pay $5/share to the buyer’s broker (otherwise, because the undelivered shares are $5 more valuable, the fail would create a $5 loan from the buyer’s broker to the seller’s broker). If the stock price falls, the buyer’s broker pays $5/share to the seller’s broker. Daily marking to market can continue indefinitely, and Boni shows that fails sometimes persisted for weeks. When the buyer decides to sell, the broker can return the original payment, plus the mark-to-market proceeds. The buyer will never know there was a failure to deliver.
What about dividends and voting rights for the naked buyer? If you don’t have shares, you don’t get to vote, and as part of marking-to-market, the naked seller will make a payment in lieu of a dividend. However, even had shares originally been delivered, they might have been subsequently loaned out, in which case you also do not have voting rights and the short-seller will pay you your dividend. The point is that naked and fully-clothed transactions are generally indistinguishable to the buyer.
Naked shorting is a natural response to the fact that it is sometimes difficult for short-sellers to locate shares of stock to borrow. Even if shares can be borrowed, the lender may charge high fees. Shorting with persistent fails is a response, and arguably makes the market more efficient. (If shorting is so onerous that negative opinion is not incorporated into the stock price, then buyers pay too high a price. Shouldn’t the SEC be concerned about this?) However, persistent fails constitute an unregulated market, which regulators abhor.
The simple fact is that politicians often don’t like market prices. If the last year has shown us anything, however, it’s that you have to respect the market, even when you don’t like it what it has to say.