Naked Short Selling: Impact on the Stock Market?

Naked Short Selling

When an investor sells a security without owning the security it is termed as a naked position. Short selling also termed Shorting which refers to selling a security when u estimate the price of a security to fall from its current traded price. An investor can sell a security when he has a possession (own) of the security or either borrows the security from a broker for trading purposes. However, in Naked short selling investor does not possess the security and short sell’s it. It s an illegal practice of short selling shares. It creates short pressure on a stock that may be larger than the tradable shares in the market. Despite being made illegal, naked shorting continues to happen because of loopholes in rules and discrepancies between paper and electronic trading systems.

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The process of naked short selling:

Usually, if someone short sells stock, their broker lends them the shares to sell. The borrowed stock could be from the inventory of the broker, a customer from another company, or another brokerage company. Shares are sold and the proceeds are credited to the account of the short seller.
In naked short selling, the sale is processed by the seller without the possession of the stock. The naked short selling tends to reduce the price of the security. The short seller then purchases the security at a lower price from a market seller and sells it to the buyer of the security. In this process, he makes a profit that is the difference between the price at which security is sold (high) and the price at which it is purchased (low). But when the security is not available in the market wherein nobody wants to sell the security or when the security is not available at a low price wherein nobody wants to sell the security at a low price the investor fails to fulfill its obligation is termed as Failure to Deliver (FTD). Naked short seller doesn’t guarantee any obligation on the part of the short seller.
As payment for the borrowing of the stock, a fee is paid to the short seller, quoted as an annualized percentage of the value of the securities borrowed- i.e. a 5 percent share borrower will be paid $5 per year for every $100 of the stock borrowed. Stock borrowing rates adjust regularly on the basis of the overall aspect of the demand and supply to borrow that particular stock.

Naked Short Selling Impact on the stock market?

Naked short selling may have a severe impact on the entire stock market. Fraudulent investors may use naked short selling as a tactic to manipulate the stock market. The sellers do not own the securities that they sell and thus sell artificial securities that are like the counterfeit of a stock. This tactic creates an apparent unfair advantage for the seller and a discrepancy in the market, as the sale side is now expanded by more shares; most of which are counterfeit. Much of these illegal trades continue unreported since only certain investment firms that are NASD affiliates are expected to comply with the delivery rules. The time frame for selling these shares is limited and be naked on the trade and the deadline is 3 days. If the seller’s broker/dealer has not located a borrow in 3 days to cover that short trade, he must repurchase the shares he has sold in the open market. This process is referred to as a “Buy-In”.

According to data compiled by the SEC and Bloomberg, naked short selling of the shares of Lehman Brothers may have played a role in the North American Financial crisis of 2007–08. Bear Stearns failed because it went bankrupt. However, the pace of the collapse of the stock price was clearly accelerated by the enormous naked short-sale activity – Robert Shapiro, former Under Secretary of Commerce. In 2008, the SEC banned what it called “abusive naked short selling” in the United States, as well as some other jurisdictions, as a method of driving down share prices. This resulted in higher pricing mistakes, higher spreads, and reduced volume trading, which has negative effect on the price discovery process and on liquidity.

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Benefits of naked short selling?

A major advantage for naked short selling is that without having to look for counter-parties willing to lend, you can short a share well in excess of floating stock or the liquidity available in that share. This unintended shortening can help markets stay in equilibrium by allowing the negative feelings to be expressed in certain stock prices. Another advantage of short selling is that some cash is freed; which can be used to purchase additional stocks. 

Author: Divya Sankhla

About the Author: Divya has completed her graduation in Bachelors of Accounting and Finance. She has worked in Deloitte Touche Tohmatsu Services, Inc. as a Research Analyst for 1 year and at JM financial as a Credit Risk Analyst for 1.3 years. She has a keen interest in learning about Financial Market. Well versed with Bloomberg, Capital Line, and Excel.


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