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Schematic representation of naked short selling in two steps. The short seller sells shares without owning them. He then purchases and delivers the shares for a different market price. If the short seller cannot afford the shares in the second step, or the shares are not available, a "fail to deliver" results.

Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shares within the required time frame, the result is known as a "failure to deliver". The transaction generally remains open until the shares are acquired by the seller, or the seller's broker settles the trade.^[1]

Short selling is used to anticipate a price fall, but exposes the seller to the risk of a price rise.

In 2008, the SEC banned what it called "abusive naked short selling"^[2] in the United States, as well as some other jurisdictions, as a method of driving down share prices. Failing to deliver shares is legal under certain circumstances, and naked short selling is not per se illegal.^[3][4][5] In the United States, naked short selling is covered by various SEC regulations which prohibit the practice.^[6]

Critics, including Overstock.com's Patrick M. Byrne, have advocated for stricter regulations against naked short selling. In 2005, "Regulation SHO" was enacted, requiring that broker-dealers have grounds to believe that shares will be available for a given stock transaction, and requiring that delivery take place within a limited time period.^[4][7]

As part of its response to the crisis in the North American markets in 2008, the SEC issued a temporary order restricting short-selling in the shares of 19 financial firms deemed systemically important, by reinforcing the penalties for failing to deliver the shares in time.^[8] Effective September 18, 2008, amid claims that aggressive short selling had played a role in the failure of financial giant Lehman Brothers, the SEC extended and expanded the rules to remove exceptions and to cover all companies, including market makers.^[2][9]

Some commentators have contended that despite regulations, naked shorting is widespread and that the SEC regulations are poorly enforced. Its critics have contended that the practice is susceptible to abuse, can be damaging to targeted companies struggling to raise capital, and has led to numerous bankruptcies.^[6][10] However, other commentators have said that the naked shorting issue is a "devil theory",^[11] not a bona fide market issue and a waste of regulatory resources.^[12]

Description[link]

"Normal" shorting[link]

Short selling is a form of speculation that allows a trader to take a "negative position" in a stock of a company. Such a trader first "borrows" shares of that stock from their owner (the lender), typically via a bank or a prime broker under the condition that he will return it on demand. Next, the trader sells the borrowed shares and delivers them to the buyer who becomes their new owner. The buyer is typically unaware that the shares have been sold short: his transaction with the trader proceeds just as if the trader owned rather than borrowed the shares. Some time later, the trader closes his short position by purchasing the same number of shares in the market and returning them to the lender.

The trader's profit is the difference between the sale price and the purchase price of the shares. In contrast to "going long" where sale succeeds the purchase, short sale precedes the purchase. Because the seller/borrower is generally required to make a cash deposit equivalent to the sale proceeds, it offers the lender some security.

Naked shorts in the United States[link]

Naked short selling is a case of short selling without first arranging a borrow. If the stock is in short supply, finding shares to borrow can be difficult. The seller may also decide not to borrow the shares, in some cases because lenders are not available, or because of the costs of lending. When shares are not borrowed within the clearing time period and the short-seller does not tender shares to the buyer, the trade is considered to have "failed to deliver."^[13] Nevertheless, the trade will continue to sit open or the buyer may be credited the shares by the DTCC until the short-seller either closes out the position or borrows the shares.^[5]

It is difficult to measure how often naked short selling occurs. Fails to deliver are not necessarily indicative of naked shorting, and can result from both "long" transactions (stock purchases) and short sales.^[4][14] Naked shorting can be invisible in a liquid market, as long as the short sale is eventually delivered to the buyer. However, if the covers are impossible to find, the trades fail. Fail reports are published regularly by the SEC,^[15] and a sudden rise in the number of fails-to-deliver will alert the SEC to the possibility of naked short selling. In some recent cases, it was claimed that the daily activity was larger than all of the available shares, which would normally be unlikely.^[13]

Extent of naked shorting[link]

The reasons for naked shorting, and the extent of it, have been disputed for several years before the SEC's 2008 action to prohibit the practice. What is generally recognized is that naked shorting tends to happen when shares are difficult to borrow. Studies have shown that naked short selling also increases with the cost of borrowing^{[citation needed]}.

In recent years, a number of companies have been accused^{[by whom?]} of using naked shorts in aggressive efforts to drive down share prices, sometimes with no intention of ever delivering the shares.^[13] These claims argue that, at least in theory, the practice allows an unlimited number of shares to be sold short. A Los Angeles Times editorial in July 2008 said that naked short selling "enables speculators to drive down a company's stock by offering an overwhelming number of shares for sale."^[16]

The SEC has stated that naked shorting is sometimes falsely asserted as a reason for a share price decline, when, often, "the price decrease is a result of the company's poor financial situation rather than the reasons provided by the insiders or promoters."^[4]

Before 2008, regulators had generally downplayed the extent of naked shorting in the US. At a North American Securities Administrators Association (NASAA) conference on naked short selling in November 2005, an official of the New York Stock Exchange stated that NYSE had not found evidence of widespread naked short selling. In 2006, an official of the SEC said that "While there may be instances of abusive short selling, 99% of all trades in dollar value settle on time without incident."^[17] Of all those that do not, 85% are resolved within 10 business days and 90% within 20.^[17] That means that about 1% of shares that change hands daily, or about $1 billion per day, are subject to delivery failures,^[5] although the SEC has stated that "fails-to-deliver can occur for a number of reasons on both long and short sales," and accordingly that they do not necessarily indicate naked short selling.^[4][14]

In 2008, SEC chairman Christopher Cox said that the SEC "has zero tolerance for abusive naked short-selling" while implementing new regulations to prohibit the practice, culminating in the September 2008 action following the failures of Bear Sterns and Lehman Brothers amidst speculation that naked short selling had played a contributory role.^[9][18] Cox said that "the rule would be designed to ensure transparency in short-selling in general, beyond the practice of naked short-selling."^[9]

Claimed effects of naked shorting[link]

As with the prevalence of naked shorting, the effects are contested. The SEC has stated that the practice can be beneficial in enhancing liquidity in difficult-to-borrow shares, while others have suggested that it adds efficiency to the securities lending market. Critics of the practice argue that it is often used for market manipulation, that it can damage companies and even that it threatens the broader markets.

One complaint about naked shorting from targeted companies is that the practice dilutes a company's shares for as long as unsettled short sales sit open on the books. This has been alleged to create "phantom" or "counterfeit" shares, sometimes going from trade to trade without connection to any physical shares, and artificially depressing the share price. However, the SEC has disclaimed the existence of counterfeit shares and stated that naked short selling would not increase a company's outstanding shares.^[7] Short seller David Rocker contended that failure to deliver securities "can be done for manipulative purposes to create the impression that the stock is a tight borrow," although he said that this should be seen as a failure to deliver "longs" rather than "shorts."^[19]

Robert J. Shapiro, former undersecretary of commerce for economic affairs, and a consultant to a law firm suing over naked shorting,^[20] has claimed that naked short selling has cost investors $100 billion and driven 1,000 companies into the ground.^[10]

Richard Fuld, the former CEO of the financial firm Lehman Brothers, during hearings on the bankruptcy filing by Lehman Brothers and bailout of AIG before the House Committee on Oversight and Government Reform alleged that a host of factors including a crisis of confidence and naked short selling attacks followed by false rumors contributed to the collapse of both Bear Stearns and Lehman Brothers.^[21] Fuld had been obsessed with short sellers and had even demoted those Lehman executives that dealt with them; he claimed that the short sellers and the rumour mongers had brought down Lehman, although he had no evidence of it.^[22] Upon the examination of the issue of whether "naked short selling" was in any way a cause of the collapse of Bear Stearns or Lehman, securities experts reached the conclusion that the alleged "naked short sales" occurred after the collapse and therefore played no role in it. House committee Chairman Henry Waxman said the committee received thousands of pages of internal documents from Lehman and these documents portray a company in which there was “no accountability for failure".^[22][23][24] In July 2008, U.S. Securities and Exchange Commission chairman Christopher Cox said there was no "unbridled naked short selling in financial issues."^[25]

Regulations in the United States[link]

Securities Exchange Act of 1934[link]

The Securities Exchange Act of 1934 stipulates a settlement period up to three business days before a stock needs to be delivered,^[13] generally referred to as "T+3 delivery."

Regulation SHO[link]

The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities, and by limiting the time in which a broker can permit failures to deliver.^[26] In addressing the first, it stated that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold.^[27] The rule had the following exemptions:

1. Broker or dealer accepting a short sale order from another registered broker or dealer
2. Bona fide market making
3. Broker-dealer effecting a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200^[28] through no fault of the customer or the broker-dealer.^[27]

To reduce the duration for which fails to deliver are permitted to sit open, the regulation requires broker-dealers to close out open fail-to-deliver positions in threshold securities that have persisted for 13 consecutive settlement days.^[26] The SEC, in describing Regulation SHO, stated that failures to deliver shares that persist for an extended period of time "may result in large delivery obligations where stock settlement occurs."^[26]

Regulation SHO also created the "Threshold Security List", which reported any stock where more than 0.5% of a company's total outstanding shares failed delivery for five consecutive days. A number of companies have appeared on the list, including Krispy Kreme, Martha Stewart Omnimedia and Delta Air Lines. The Motley Fool, an investment website, observes that "when a stock appears on this list, it is like a red flag waving, stating 'something is wrong here!'"^[13] However, the SEC clarified that appearance on the threshold list "does not necessarily mean that there has been abusive naked short selling or any impermissible trading in the stock."^[26]

In July 2006, the SEC proposed to amend Regulation SHO, to further reduce failures to deliver securities.^[29] SEC Chairman Christopher Cox referred to "the serious problem of abusive naked short sales, which can be used as a tool to drive down a company's stock price" and that the SEC is "concerned about the persistent failures to deliver in the market for some securities that may be due to loopholes in Regulation SHO".^[30]

Developments, 2007 to the present[link]

In June 2007, the SEC voted to remove the grandfather provision that allowed fails-to-deliver that existed before Reg SHO to be exempt from Reg SHO. SEC Chairman Christopher Cox called naked short selling "a fraud that the commission is bound to prevent and to punish." The SEC also said it was considering removing an exemption from the rule for options market makers.^[31] Removal of the grandfather provision and naked shorting restrictions generally have been endorsed by the U.S. Chamber of Commerce.^[32]

In March 2008, SEC Chairman Christopher Cox gave a speech entitled the "'Naked' Short Selling Anti-Fraud Rule," in which he announced new SEC efforts to combat naked short selling.^[33] Under the proposal, the SEC would create an antifraud rule targeting those who knowingly deceive brokers about having located securities before engaging in short sales, and who fail to deliver the securities by the delivery date. Cox said the proposal would address concerns about short-selling abuses, particularly in the market for small-cap stocks. Even with the regulation in place, the SEC received hundreds of complaints in 2007 about alleged abuses involving short sales. The SEC estimated that about 1% of shares that changed hands daily, about $1 billion, were subject to delivery failures. SEC Commissioners Paul Atkins and Kathleen Casey expressed support for the crackdown.^[34][35]

In mid-July 2008, the SEC announced emergency actions to limit the naked short selling of government sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, in an effort to limit market volatility of financial stocks.^[36] But even with respect to those stocks the SEC soon thereafter announced there would be an exception with regard to market makers.^[37] SEC Chairman Cox noted that the emergency order was "not a response to unbridled naked short selling in financial issues", saying that "that has not occurred". Cox said, "rather it is intended as a preventative step to help restore market confidence at a time when it is sorely needed."^[25] Analysts warned of the potential for the creation of price bubbles.^[37][38]

The emergency actions rule expired August 12, 2008.^{[39][40][41][42]} However, at September 17, 2008, the SEC issued new, more extensive rules against naked shorting, making "it crystal clear that the SEC has zero tolerance for abusive naked short selling". Among the new rules is that market makers are no longer given an exception. As a result, options market makers will be treated in the same way as all other market participants, and effectively will be banned from naked short selling.^[43]

On November 4, 2008, voters in South Dakota considered a ballot initiative, "The South Dakota Small Investor Protection Act", to end naked short selling in that state. The Securities Industry and Financial Markets Association of Washington and New York said they would take legal action if the measure passed.^[44] The voters defeated the initiative.^[45]

In July 2009, the SEC, under what the Wall Street Journal described as "intense political pressure," made permanent an interim rule that obliges brokerages to promptly buy or borrow securities when executing a short sale.^[46] The SEC said that since the fall of 2008, abusive naked short selling had been reduced by 50%, and the number of threshold list securities (equity securities with too many "fails to deliver") declined from 582 in July 2008 to 63 in March 2009.^[47][48]

In January 2010, Mary Schapiro, chairperson of the SEC, testified before the U.S. Financial Crisis Inquiry Commission, fails to deliver in equity securities has declined 63.4 percent, while persistent and large fails have declined 80.5 percent.^[3]

Regulations outside of the United States[link]

Several international exchanges have either partially or fully restricted the practice of naked short selling of shares. They include Australia's Australian Securities Exchange,^[49] India's Securities and Exchange Board,^[50] the Netherlands's Euronext Amsterdam,^[51] Japan's Tokyo Stock Exchange,^[52] and Switzerland's SWX Swiss Exchange.^[53][54] Also Spain's securities regulator CNMV.^[55]

In March 2007, the Securities and Exchange Board of India (SEBI), which disallowed short sales altogether in 2001 as a result of the Ketan Parekh affair, reintroduced short selling under regulations similar to those developed in the United States. In conjunction with this rule change, SEBI outlawed all naked short selling.^[56][57]

Japan's naked shorting ban started on November 4, 2008, and was originally scheduled to run until July 2009, but was extended through October of that year.^[58][59] Japan's Finance Minister, Shōichi Nakagawa stated, "We decided (to move up the short-selling ban) as we thought it could be dangerous for the Tokyo stock market if we do not take action immediately." Nakagawa added that Japan's Financial Services Agency would be teaming with the Securities and Exchange Surveillance Commission and Tokyo Stock Exchange to investigate past violations of Japanese regulations on stock short-selling. The ban was subsequently extended through October 2010.^[60]

The Singapore Exchange started to penalize naked short sales with an interim measure in September, 2008. These initial penalties started at $100 per day. In November, they announced plans to increase the fines for failing to complete trades. The new penalties would penalize traders who fail to cover their positions, starting at $1,000 per day. There would also be fines for brokerages who fail to use the exchange's buying-in market to cover their positions, starting at $5,000 per day. The Singapore exchange had stated that the failure to deliver shares inherent in naked short sales threatened market orderliness.^[61]

On May 18, 2010, the German Minister of Finance announced that naked short sales of euro-denominated government bonds, credit default swaps based on those bonds, and shares in Germany's ten leading financial institutions will be prohibited. This ban went into effect that night and was set to expire on March 31, 2011.^[62][63] On May 28, German financial market regulator BaFin announced that this ban would be permanent.^[64] The ban is effective July 27, 2010.^[65] The International Monetary Fund issued a report in August 2010 saying that the measure succeeded only in impeding the markets. It said the ban "did relatively little to support the targeted institutions’ underlying stock prices, while liquidity dropped and volatility rose substantially." The IMF said there was no strong evidence that stock prices fell because of shorting.^[66]

In August 2011, France, Italy, Spain, Belgium and South Korea temporally banned all short selling in their financial stocks,^[67] while Germany pushed for an eurozone-wide ban on naked short selling.^[68]

Regulatory enforcement actions[link]

In 2005, the SEC notified Refco of intent to file an enforcement action against the securities unit of Refco for securities trading violations concerning the shorting of Sedona stock. The SEC sought information related to two former Refco brokers who handled the account of a client, Amro International, which shorted Sedona's stock.^[69] No charges had been filed by 2007.

In December 2006, the SEC sued Gryphon Partners, a hedge fund, for insider trading and naked short-selling involving PIPEs in the unregistered stock of 35 companies. PIPEs are "private investments in public equities," used by companies to raise cash. The naked shorting took place in Canada, where it was legal at the time. Gryphon denied the charges.^[70]

In March 2007, Goldman Sachs was fined $2 million by the SEC for allowing customers to illegally sell shares short prior to secondary public offerings. Naked short-selling was allegedly used by the Goldman clients. The SEC charged Goldman with failing to ensure those clients had ownership of the shares. SEC Chairman Cox said "That is an important case and it reflects our interest in this area."^[71]

In July 2007, Piper Jaffray was fined $150,000 by the New York Stock Exchange (NYSE). Piper violated securities trading rules from January through May 2005, selling shares without borrowing them, and also failing to "cover short sales in a timely manner", according to the NYSE.^[72] At the time of this fine, the NYSE had levied over $1.9 million in fines for naked short sales over seven regulatory actions.^[73]

Also in July 2007, the American Stock Exchange fined two options market makers for violations of Regulation SHO. SBA Trading was sanctioned for $5 million, and ALA Trading was fined $3 million, which included disgorgement of profits. Both firms and their principals were suspended from association with the exchange for five years. The exchange said the firms used an exemption to Reg. SHO for options market makers to "impermissibly engage in naked short selling."^[74][75][76]

In October 2007, the SEC settled charges against New York hedge fund adviser Sandell Asset Management Corp. and three executives of the firm for, among other things, shorting stock without locating shares to borrow. Fines totalling $8 million were imposed, and the firm neither admitted nor denied the charges.^[77]

In October 2008 Lehman Brothers Inc. was fined $250,000 by the Financial Industry Regulatory Authority (FINRA) for failing to properly document the ownership of short sales as they occurred, and for failing to annotate an affirmative declaration that shares would be available by the settlement date.^[78]

In April 2010 Goldman Sachs paid $450,000 to settle SEC's allegations that it had failed to deliver "approximatedly" 86 short sells between early December 2008 and mid-January 2009, and that it had failed to institute adequate controls to prevent the failures. The company neither admitted nor denied any wrongdoing.^[79]

Litigation and DTCC[link]

The Depository Trust and Clearing Corporation (DTCC) has been criticized for its approach to naked short selling.^[5][80] DTCC has been sued with regard to its alleged participation in naked short selling, and the issue of DTCC's possible involvement has been taken up by Senator Robert Bennett and discussed by the NASAA and in articles in the Wall Street Journal and Euromoney.

There is no dispute that illegal naked shorting happens,^[5][81] what is in dispute is how much it happens, and to what extent is DTCC to blame.^[5][82] Some companies with falling stocks blame DTCC as the keeper of the system where it happens, and say DTCC turns a blind eye to the problem.^[5] Referring to trades that remain unsettled, DTCC's chief spokesman Stuart Goldstein said, "We're not saying there is no problem, but to suggest the sky is falling might be a bit overdone."^[83][84] In July 2007, Senator Bennett suggested on the U.S. Senate floor that the allegations involving DTCC and naked short selling are "serious enough" that there should be a hearing on them with DTCC officials by the Senate Banking Committee, and that banking committee chairman Christopher Dodd has expressed a willingness to hold such a hearing.^[85]

Critics also contend DTCC has been too secretive with information about where naked shorting is taking place.^[5] Ten suits concerning naked short-selling filed against the DTCC were withdrawn or dismissed by May 2005.^[86]

A suit by Electronic Trading Group, naming major Wall Street brokerages, was filed in April 2006 and dismissed in December 2007.^[87][88]

Two separate lawsuits, filed in 2006 and 2007 by NovaStar Financial, Inc. shareholders and Overstock.com, named as defendants ten Wall Street prime brokers. They claimed a scheme to manipulate the companies' stock by allowing naked short selling.^[89] A motion to dismiss the Overstock suit was denied in July 2007.^[90][91]

A suit against DTCC by Pet Quarters Inc. was dismissed by a federal court in Arkansas, and upheld by the Eighth Circuit Court of Appeals in March 2009.^[92] Pet Quarters alleged the Depository Trust & Clearing Corp.'s stock-borrow program resulted in the creation of nonexistent or phantom stock and contributed to the illegal short selling of the company's shares. The court ruled: "In short, all the damages that Pet Quarters claims to have suffered stem from activities performed or statements made by the defendants in conformity with the program's Commission approved rules. We conclude that the district court did not err in dismissing the complaint on the basis of preemption." Pet Quarters' complaint was almost identical to suits against DTCC brought by Whistler Investments Inc. and Nanopierce Technologies Inc. The suits also challenged DTCC's stock-borrow program, and were dismissed.^[93]

Studies[link]

A study of trading in initial public offerings by two SEC staff economists, published in April 2007, found that excessive numbers of fails to deliver were not correlated with naked short selling. The authors of the study said that while the findings in the paper specifically concern IPO trading, "The results presented in this paper also inform a public debate surrounding the role of short selling and fails to deliver in price formation."^[94]

In contrast, a study by Leslie Boni in 2004 found correlation between "strategic delivery failures" and the cost of borrowing shares. The paper, which looked at a "unique dataset of the entire cross-section of U.S. equities," credited the initial recognition of strategic delivery fails to Richard Evans, Chris Geczy, David Musto and Adam Reed, and found its review to provide evidence consistent with their hypothesis that "market makers strategically fail to deliver shares when borrowing costs are high." A recent study by Autore, Boulton, and Braga-Alves examines stock returns around delivery failures between 2005 and 2008 and finds evidence consistent with a positive link between delivery failures and borrowing costs.

An April 2007 study conducted for Canadian market regulators by Market Regulation Services Inc. found that fails to deliver securities were not a significant problem on the Canadian market, that "less than 6% of fails resulting from the sale of a security involved short sales" and that "fails involving short sales are projected to account for only 0.07% of total short sales.^[95]

A Government Accountability Office study, released in June 2009, found that recent SEC rules had apparently reduced abusive short selling, but that the SEC needed to give clearer guidance to the brokerage industry.^[96]

The Financial Crisis Inquiry Commission, appointed by Congress to investigate the 2008 financial crisis, makes no reference to naked shorting, or short-selling of financial stocks, in its conclusions.^[97]

Media coverage[link]

Some journalists have expressed concern about naked short selling, while others contend that naked short selling is not harmful and that its prevalence has been exaggerated by corporate officials seeking to blame external forces for internal problems with their companies.^[98] Others have discussed naked short selling as a confusing or bizarre form of trading.^[99]

In June 2007, executives of Universal Express, which had claimed naked shorting of its stock, were sanctioned by a federal court judge for violation of securities laws.^[100] Referring to a court ruling against CEO Richard Altomare, New York Times columnist Floyd Norris said: "In Altomare's view, the issues that bothered the judge are irrelevant. Long and short of it, this is a naked short hallmark case in the making. Or it is proof that it can take a long time for the SEC to stop a fraud."^[101] Universal Express claimed that 6,000 small companies had been put out of business by naked shorting, which the company said "the SEC has ignored and condoned."^[102]

Reviewing the SEC's July 2008 emergency order, Barron's said in an editorial: "Rather than fixing any of the real problems with the agency and its mission, Cox and his fellow commissioners waved a newspaper and swatted the imaginary fly of naked short-selling. It made a big noise, but there's no dead bug."^[12] Holman Jenkins of the Wall Street Journal said the order was "an exercise in symbolic confidence-building" and that naked shorting involved technical concerns except for subscribers to a "devil theory".^[11] The Economist said the SEC had "picked the wrong target", mentioning a study by Arturo Bris of the Swiss International Institute for Management Development who found that trading in the 19 financial stocks became less efficient.^[103] The Washington Post expressed approval of the SEC's decision to address a "frenetic shadow world of postponed promises, borrowed time, obscured paperwork and nail-biting price-watching, usually compressed into a few high-tension days swirling around the decline of a company."^[104] The Los Angeles Times called the practice of naked short selling "hard to defend," and stated that it was past time the SEC became active in addressing market manipulation.^[105]

The Wall Street Journal said in an editorial in July 2008 that "the Beltway is shooting the messenger by questioning the price-setting mechanisms for barrels of oil and shares of stock." But it said the emergency order to bar naked short selling "won't do much harm," and said "Critics might say it's a solution to a nonproblem, but the SEC doesn't claim to be solving a problem. The Commission's move is intended to prevent even the possibility that an unscrupulous short seller could drive down the shares of a financial firm with a flood of sell orders that aren't backed by an actual ability to deliver the shares to buyers."^[106]

In an article in March 2009 Bloomberg News Service said that the Lehman Brothers bankruptcy may have been prevented by curbs on naked shorting. "..as many as 32.8 million shares in the company were sold and not delivered to buyers on time as of Sept. 11, according to data compiled by the Securities and Exchange Commission.."^[107]

In May 2009, the New York Times's chief financial correspondent Floyd Norris reported that naked shorting is "almost gone." He said that delivery failures, where they occur, are quickly corrected.^[108]

In an article published in October 2009, Rolling Stone writer Matt Taibbi contended that Bear Stearns and Lehman Brothers were flooded with "counterfeit stock" that helped kill both companies. Taibbi said that the two firms got a "push" into extinction from "a flat-out counterfeiting scheme called naked short-selling".^[109] During a May 2010 discussion on the inclusion of 'counterfeiting' in the charges filed against Icelandic bankers, the host Max Keiser speculated that the charge might refer to naked short selling because "naked short-selling is the same as counterfeiting, in that it is selling something that doesn't exist."^[110]

See also[link]

• Locate (finance)‎
• Easy to borrow
• Market maker

References[link]

External links[link]

• Short Selling FAQ: Securities and Exchange Commission
• Naked Short Selling FAQ: Depository Trust and Clearing Corp.
• AMEX's daily and monthly Regulation SHO threshold security list
• NYSE's Regulation SHO threshold security list
• NASDAQ's Regulation SHO threshold security list
• SEC stock delivery failures charted.
• In pursuit of the Naked Short in New York University Journal of Law and Business

In finance, short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. The short seller will incur a loss if the price of the assets rises (as it will have to buy them at a higher price than it sold them), and the loss that can be incurred by a short seller is only limited by the total strike price. Other costs of shorting may include a fee for borrowing the assets and payment of any dividends paid on the borrowed assets. "Shorting" and "going short" also refer to entering into any derivative or other contract under which the investor similarly profits from a fall in the value of an asset. Mathematically, short selling is equivalent to buying a negative amount of the assets.

Short selling is almost always conducted with assets traded in public securities, commodities or currency markets, as on such markets the amount being made or lost can be monitored in real time and it is generally possible to buy back the borrowed assets whenever required. Because such assets are fungible, any assets of the same type bought on those markets can be used to return to the lender.

Going short can be contrasted with the more conventional practice of "going long", whereby an investor profits from any increase in the price of the asset.

Schematic representation of short selling in two steps. The short seller borrows shares and immediately sells them. He then waits, hoping for the stock price to decrease, when the seller can profit by purchasing the shares to return to the lender.

Concept[link]

To profit from a decrease in the price of a security, a short seller can borrow the security and sell it expecting that it will be cheaper to repurchase in the future. When the seller decides that the time is right (or when the lender recalls the securities), the seller buys equivalent securities and returns them to the lender. The process relies on the fact that the securities (or the other assets being sold short) are fungible; the term "borrowing" is therefore used in the sense of borrowing $10, where a different $10 note can be returned to the lender (as opposed to borrowing a car, where the same car must be returned).

A short seller typically borrows through a broker, who is usually holding the securities for another investor who owns the securities; the broker himself seldom purchases the securities to lend to the short seller.^[1] The lender does not lose the right to sell the securities while they have been lent, as the broker will usually hold a large pool of such securities for a number of investors which, as such securities are fungible, can instead be transferred to any buyer. In most market conditions there is a ready supply of securities to be borrowed, held by pension funds, mutual funds and other investors.

The act of buying back the securities that were sold short is called "covering the short" or "covering the position". A short position can be covered at any time before the securities are due to be returned. Once the position is covered, the short seller will not be affected by any subsequent rises or falls in the price of the securities, as he already holds the securities required to repay the lender.

The terms shorting and going short are also used as blanket terms for tactics that allow an investor to gain from the decline in price of a security. Such tactics are generally based on a derivative contract, such as an option, a future or a similar synthetic position. For example, a put option consists of the right to sell an asset at a given strike price; the owner of the option therefore benefits when the market price of the asset falls below that price, as he can buy the asset at the lower price and sell it under the option at the strike price. Similarly, a short position in a futures contract means the holder of the position has an obligation to sell the underlying asset later at a given price; if the price falls below the given price, the person with the short position can buy the asset at the lower price and sell it under the future at the higher price.

Worked examples[link]

Profitable trade[link]

Shares in C & Company currently trade at $10 per share.

1. A short seller borrows 100 shares of C & Company and immediately sells them for a total of $1,000.
2. Subsequently, the price of the shares falls to $8 per share.
3. Short seller now buys 100 shares of C & Company for $800.
4. Short seller returns the shares to the lender, who must accept the return of the same number of shares as was lent despite the fact that the market value of the shares has decreased.
5. Short seller retains as profit the $200 difference (minus borrowing fees) between the price at which he sold the shares he borrowed and the lower price at which he was able to purchase the shares he returned.

Loss-making trade[link]

Shares in C & Company currently trade at $10 per share.

1. A short seller borrows 100 shares of C & Company and immediately sells them for a total of $1,000.
2. Subsequently the price of the shares rises to $25.
3. Short seller is required to return the shares, and to meet the obligation is compelled to buy 100 shares of C & Company for $2,500.
4. Short seller returns the shares to the lender who accepts the return of the same number of shares as was lent.
5. Short seller incurs as a loss the $1,500 difference between the price at which he sold the shares he borrowed and the higher price at which he had to purchase the shares he returned (plus borrowing fees).

Comparison with long positions[link]

Short selling is the opposite of "going long". A short seller takes a negative, or "bearish", stance, believing that the price of a security will fall. Investors who employ short selling often use it to allow them to profit on trading in securities which they believe are overvalued, just as traditional long investors attempt to profit on securities which are undervalued by buying them.

Because a short position is the opposite of a long position, many features of the position are reversed in comparison. In particular, the profit (rather than the loss) is limited to the value of the security, but the loss (rather than the profit) is theoretically unlimited. In practice, as the price of a security rises the short seller will receive a margin call from the broker, demanding that the short seller either cover his short position (by purchasing the security) or provide additional cash in order to meet the margin requirement for the security, which effectively places a limit on the amount that can be lost.

History[link]

Some hold that the practice was invented in 1609 by Dutch merchant Isaac Le Maire, a sizeable shareholder of the Vereenigde Oostindische Compagnie (VOC).^[2]

Short selling has been a target of ire ever since.^{[citation needed]} In the eighteenth century, England banned it outright.^[3] The London banking house of Neal, James, Fordyce and Down collapsed in June 1772, precipitating a major crisis which included the collapse of almost every private bank in Scotland, and a liquidity crisis in the two major banking centres of the world, London and Amsterdam. The bank had been speculating by shorting East India Company stock on a massive scale, and apparently using customer deposits to cover losses. It was perceived^{[citation needed]} as having a magnifying effect in the violent downturn in the Dutch tulip market in the eighteenth century. In another well-referenced example, George Soros became notorious for "breaking the Bank of England" on Black Wednesday of 1992, when he sold short more than $10 billion worth of pounds sterling.

The term "short" was in use from at least the mid-nineteenth century. It is commonly understood that "short" is used because the short-seller is in a deficit position with his brokerage house. Jacob Little was known as The Great Bear of Wall Street who began shorting stocks in the United States in 1822.^[4]

Short sellers were blamed for the Wall Street Crash of 1929.^[5] Regulations governing short selling were implemented in the United States in 1929 and in 1940.^{[citation needed]} Political fallout from the 1929 crash led Congress to enact a law banning short sellers from selling shares during a downtick; this was known as the uptick rule, and this was in effect until July 3, 2007 when it was removed by the SEC (SEC Release No. 34-55970).^[6] President Herbert Hoover condemned short sellers and even J. Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression.^{[citation needed]} A few years later, in 1949, Alfred Winslow Jones founded a fund (that was unregulated) that bought stocks while selling other stocks short, hence hedging some of the market risk, and the hedge fund was born.^[7]

Negative news, such as litigation against a company, may also entice professional traders to sell the stock short.^{[citation needed]}

During the Dot-com bubble, shorting a start-up company could backfire since it could be taken over at a price higher than the price at which speculators shorted.^{[citation needed]} Short-sellers were forced to cover their positions at acquisition prices, while in many cases the firm often overpaid for the start-up.^{[citation needed]}

Naked short selling restrictions in 2008[link]

In September 2008 short selling, exacerbated by naked short selling,^[8] was seen as a contributing factor to undesirable market volatility, and was subsequently prohibited by the U.S. Securities and Exchange Commission (SEC) for 799 financial companies for three weeks in an effort to stabilize those companies.^[9] At the same time the U.K. Financial Services Authority (FSA) prohibited short selling for 32 financial companies.^[10] On September 22, Australia enacted even more extensive measures with a total ban of short selling.^[11] Also on September 22, the Spanish market regulator, CNMV, required investors to notify it of any short positions in financial institutions, if they exceed 0.25% of a company's share capital, and it also restricted naked shorting.^[12]

In an interview with the Washington Post in late December 2008, U.S. Securities and Exchange Commission Chairman Christopher Cox said that the decision to impose a three-week ban on short selling of financial company stocks was taken reluctantly, but that the view at the time, from Treasury Secretary Henry M. Paulson and Federal Reserve chairman Ben S. Bernanke, was that "if we did not act, and act at that instant, these financial institutions could fail as a result and there would be nothing left to save." Later he changed his mind and thought the ban unproductive.^[13] In a December 2008 interview with Reuters, he explained that the SEC's Office of Economic Analysis was still evaluating data from the temporary ban, and that preliminary findings point to several unintended market consequences and side effects. "While the actual effects of this temporary action will not be fully understood for many more months, if not years," he said, "knowing what we know now, I believe on balance the Commission would not do it again.”^[14]

Naked short selling restrictions in European economic crisis[link]

In June 2010, due to the economical crisis Germany permanently banned naked short selling.^[15]

In August 2011, France, Italy, Spain, Belgium and South Korea banned all short selling in their financial stocks.^[16]

Mechanism[link]

Short selling stock consists of the following:

• The investor instructs the broker to sell the shares and the proceeds are credited to his broker's account at the firm upon which the firm can earn interest. Generally, the short seller does not earn interest on the short proceeds and cannot use or encumber the proceeds for another transaction.^[17]

• Upon completion of the sale, the investor has 3 days (in the US) to borrow the shares. If required by law, the investor first ensures that cash or equity is on deposit with his brokerage firm as collateral for the initial short margin requirement. Some short sellers, mainly firms and hedge funds, participate in the practice of naked short selling, where the shorted shares are not borrowed or delivered.

• The investor may close the position by buying back the shares (called covering). If the price has dropped, he makes a profit. If the stock advanced, he takes a loss.

• Finally, the investor may return the shares to the lender or stay short indefinitely.

• At any time, the lender may call for the return of his shares e.g. because he wants to sell them. The borrower must buy shares on the market and return them to the lender (or he must borrow the shares from elsewhere). When the broker completes this transaction automatically, it is called a 'buy-in'.

Shorting stock in the U.S.[link]

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate.” Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security.

The vast majority of stocks borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies (see list below). Institutions often lend out their shares in order to earn a little extra money on their investments. These institutional loans are usually arranged by the custodian who holds the securities for the institution. In an institutional stock loan, the borrower puts up cash collateral, typically 102% of the value of the stock. The cash collateral is then invested by the lender, who often rebates part of the interest to the borrower. The interest that is kept by the lender is the compensation to the lender for the stock loan.

Brokerage firms can also borrow stocks from the accounts of their own customers. Typical margin account agreements give brokerage firms the right to borrow customer shares without notifying the customer. In general, brokerage accounts are only allowed to lend shares from accounts for which customers have "debit balances", meaning they have borrowed from the account. SEC Rule 15c3-3 imposes such severe restrictions on the lending of shares from cash accounts or excess margin (fully paid for) shares from margin accounts that most brokerage firms do not bother except in rare circumstances. (These restrictions include that the broker must have the express permission of the customer and provide collateral or a letter of credit.)

Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.

Stock exchanges such as the NYSE or the NASDAQ typically report the "short interest" of a stock, which gives the number of shares that have been legally sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio, which is the number of shares legally sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements but in order to be reliable, investors must also ascertain the number of shares brought into existence by naked shorters. Investors are cautioned to remember that for every share that has been shorted (owned by a new owner), a 'shadow owner' exists (i.e. the original owner) who also is part of the universe of owners of that stock, i.e. Despite not having any voting rights, he has not relinquished his interest and some rights in that stock.

Securities lending[link]

When a security is sold, the seller is contractually obligated to deliver it to the buyer. If a seller sells a security short without owning it first, the seller needs to borrow the security from a third party to fulfill its obligation. Otherwise, the seller will "fail to deliver," the transaction will not settle, and the seller may be subject to a claim from its counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income, a process known as securities lending. The lender receives a fee for this service. Similarly, retail investors can sometimes make an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.

Sources of short interest data[link]

Time delayed short interest data (for legally shorted shares) is available in a number of countries, including the US, the UK, Hong Kong, and Spain. The amount of stocks being shorted on a global basis has increased in recent years for various structural reasons (e.g. the growth of 130/30 type strategies, short or bear ETFs). The data is typically delayed; for example, the NASDAQ requires its broker-dealer member firms to report data on the 15th of each month, and then publishes a compilation eight days later.^[18]

Some market data providers (like Data Explorers and SunGard Financial Systems^[19]) believe that stock lending data provides a good proxy for short interest levels (excluding any naked short interest). SunGard provides daily data on short interest by tracking the proxy variables based on borrowing and lending data which it collects.^[20]

Short selling terms[link]

Days to Cover (DTC) is a numerical term that describes the relationship between the amount of shares in a given equity that have been legally short sold and the number of days of typical trading that it would require to 'cover' all legal short positions outstanding. For example, if there are ten million shares of XYZ Inc. that are currently legally short sold and the average daily volume of XYZ shares traded each day is one million, it would require ten days of trading for all legal short positions to be covered (10 million / 1 million).

Short Interest is a numerical term that relates the number of shares in a given equity that have been legally shorted divided by the total shares outstanding for the company, usually expressed as a percent. For example, if there are ten million shares of XYZ Inc. that are currently legally short sold, and the total number of shares issued by the company is one hundred million, the Short Interest is 10% (10 million / 100 million). If however, shares are being created through naked short selling, "fails" data must be accessed to assess accurately the true level of short interest.

Major lenders[link]

• Merrill Lynch (New Jersey)
• State Street Corporation (Boston)
• JP Morgan Chase (New York)
• Northern Trust (Chicago)
• Fortis (Amsterdam, now defunct)
• ABN AMRO (Amsterdam, Netherlands, formerly Fortis)
• Citibank (New York)
• Bank of New York Mellon Corporation (New York)
• UBS AG (Zurich, Switzerland)
• Barclays (London, England)

Naked short selling[link]

A naked short sale occurs when a security is sold short without borrowing the security within a set time, 3 days (T+3) in the US. This means that the buyer of such a short is buying the short-seller's promise to deliver a share, rather than buying the share itself. The short-seller's promise is known as a hypothecated share.

When the holder of the underlying stock receives a dividend, the holder of the hypothecated share would receive an equal dividend from the short seller.

Naked shorting has been made illegal except where allowed under limited circumstances by market makers. It is detected by the Depository Trust & Clearing Corporation (in the US) as a "failure to deliver" or simply "fail.” While many fails are settled in a short time, some have been allowed to linger in the system.

In the US, arranging to borrow a security before a short sale is called a locate. In 2005, to prevent widespread failure to deliver securities, the U.S. Securities and Exchange Commission (SEC) put in place Regulation SHO, intended to prevent investors from selling some stocks short before doing a locate. Requirements that are more stringent were put in place in September 2008, ostensibly to prevent the practice from exacerbating market declines. The rules were made permanent in 2009.

Fees[link]

When a broker facilitates the delivery of a client's short sale, the client is charged a fee for this service, usually a standard commission similar to that of purchasing a similar security.

If the short position begins to move against the holder of the short position (i.e., the price of the security begins to rise), money will be removed from the holder's cash balance and moved to his or her margin balance. If short shares continue to rise in price, and the holder does not have sufficient funds in the cash account to cover the position, the holder will begin to borrow on margin for this purpose, thereby accruing margin interest charges. These are computed and charged just as for any other margin debit. Therefor only margin accounts can be used to open a short position.

When a security's ex-dividend date passes, the dividend is deducted from the shortholder's account and paid to the person from whom the stock is borrowed.

For some brokers, the short seller may not earn interest on the proceeds of the short sale or use it to reduce outstanding margin debt. These brokers may not pass this benefit on to the retail client unless the client is very large. The interest is often split with the lender of the security.

Dividends and voting rights[link]

Where shares have been shorted and the company which issues the shares distributes a dividend, the question arises as to who receives the dividend. The new buyer of the shares, who is the "holder of record" and holds the shares outright, will receive the dividend from the company. However, the lender, who may hold its shares in a margin account with a prime broker and is unlikely to be aware that these particular shares are being lent out for shorting, also expects to receive a dividend. The short seller will therefore pay to the lender an amount equal to the dividend in order to compensate, though as this payment does not come from the company it is not technically a dividend as such. The short seller is therefore said to be "short the dividend".

A similar issue comes up with the voting rights attached to the shorted shares. Unlike a dividend, voting rights cannot legally be synthesized and so the buyer of the shorted share, as the holder of record, controls the voting rights. The owner of a margin account from which the shares were lent will have agreed in advance to relinquish voting rights to shares during the period of any short sale.^[21] As noted earlier, victims of Naked Shorting attacks sometimes report that the number of votes cast is greater than the number of shares issued by the company.^[22]

Markets[link]

Futures and options contracts[link]

When trading futures contracts, being 'short' means having the legal obligation to deliver something at the expiration of the contract, although the holder of the short position may alternately buy back the contract prior to expiration instead of making delivery. Short futures transactions are often used by producers of a commodity to fix the future price of goods they have not yet produced. Shorting a futures contract is sometimes also used by those holding the underlying asset (i.e. those with a long position) as a temporary hedge against price declines. Shorting futures may also be used for speculative trades, in which case the investor is looking to profit from any decline in the price of the futures contract prior to expiration.

An investor can also purchase a put option, giving that investor the right (but not the obligation) to sell the underlying asset (such as shares of stock) at a fixed price. In the event of a market decline, the option holder may exercise these put options, obliging the counterparty to buy the underlying asset at the agreed upon (or "strike") price, which would then be higher than the current quoted spot price of the asset.

Currency[link]

Selling short on the currency markets is different from selling short on the stock markets. Currencies are traded in pairs, each currency being priced in terms of another. In this way, selling short on the currency markets is identical to going long on stocks.

Novice traders or stock traders can be confused by the failure to recognize and understand this point: a contract is always long in terms of one medium and short another.

When the exchange rate has changed, the trader buys the first currency again; this time he gets more of it, and pays back the loan. Since he got more money than he had borrowed initially, he makes money. Of course, the reverse can also occur.

An example of this is as follows: Let us say a trader wants to trade with the US dollar and the Indian rupee currencies. Assume that the current market rate is USD 1 to Rs.50 and the trader borrows Rs.100. With this, he buys USD 2. If the next day, the conversion rate becomes USD 1 to Rs.51, then the trader sells his USD 2 and gets Rs.102. He returns Rs.100 and keeps the Rs.2 profit (minus fees).

One may also take a short position in a currency using futures or options; the preceding method is used to bet on the spot price, which is more directly analogous to selling a stock short.

Risks[link]

This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. (April 2009)

Note: this section does not apply to currency markets.

Short selling is sometimes referred to as a "negative income investment strategy" because there is no potential for dividend income or interest income. Stock is held only long enough to be sold pursuant to the contract, and one's return is therefore limited to short term capital gains, which are taxed as ordinary income. For this reason, buying shares (called "going long") has a very different risk profile from selling short. Furthermore, a "long's" losses are limited because the price can only go down to zero, but gains are not, as there is no limit, in theory, on how high the price can go. On the other hand, the short seller's possible gains are limited to the original price of the stock, which can only go down to zero, whereas the loss potential, again in theory, has no limit. For this reason, short selling probably is most often used as a hedge strategy to manage the risks of long investments.

Many short sellers place a "stop order" with their stockbroker after selling a stock short. This is an order to the brokerage to cover the position if the price of the stock should rise to a certain level, in order to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock's price skyrockets, the stockbroker may decide to cover the short seller's position immediately and without his consent, in order to guarantee that the short seller will be able to make good on his debt of shares.

Short sellers must be aware of the potential for a short squeeze. When the price of a stock rises significantly, some people who are shorting the stock will cover their positions to limit their losses (this may occur in an automated way if the short sellers had stop-loss orders in place with their brokers); others may be forced to close their position to meet a margin call; others may be forced to cover, subject to the terms under which they borrowed the stock, if the person who lent the stock wishes to sell and take a profit. Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering. Because of this, most short sellers restrict their activities to heavily traded stocks, and they keep an eye on the "short interest" levels of their short investments. Short interest is defined as the total number of shares that have been legally sold short, but not covered. A short squeeze can be deliberately induced. This can happen when large investors (such as companies or wealthy individuals) notice significant short positions, and buy many shares, with the intent of selling the position at a profit to the short sellers who will be panicked by the initial uptick or who are forced to cover their short positions in order to avoid margin calls.

Another risk is that a given stock may become "hard to borrow." As defined by the SEC and based on lack of availability, a broker may charge a hard to borrow fee daily, without notice, for any day that the SEC declares a share is hard to borrow. Additionally, a broker may be required to cover a short seller's position at any time ("buy in"). The short seller receives a warning from the broker that he is "failing to deliver" stock, which will lead to the buy-in.^[23]

Because short sellers must deliver the shorted securities to their broker eventually, and will need money to buy them, there is a credit risk for the broker. The penalties for failure to deliver on a short selling contract inspired financier Daniel Drew to warn: "He who sells what isn't his'n, Must buy it back or go to pris'n." To manage its own risk, the broker requires the short seller to keep a margin account, and charges interest of between 2% and 8% depending on the amounts involved.^[24]

In 2011, the eruption of the massive China stock frauds on North American equity markets brought a related risk to light for the short seller. The efforts of research-oriented short sellers to expose these frauds eventually prompted NASDAQ, NYSE and other exchanges to impose sudden, lengthy trading halts that froze the values of shorted stocks at artificially high values. Reportedly in some instances, brokers charged short sellers excessively large amounts of interest based on these high values as the shorts were forced to continue their borrowings at least until the halts were lifted.^[25]

Short sellers tend to temper overvaluation by selling into exuberance. Likewise, short sellers are said to provide price support by buying when negative sentiment is exacerbated after a significant price decline. Short selling can have negative implications if it causes a premature or unjustified share price collapse when the fear of cancellation due to bankruptcy becomes contagious.^[26]

Strategies[link]

Hedging[link]

Hedging often represents a means of minimizing the risk from a more complex set of transactions. Examples of this are:

• A farmer who has just planted his wheat wants to lock in the price at which he can sell after the harvest. He would take a short position in wheat futures.
• A market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. This can create substantial bond positions. The largest risk is that interest rates overall move. The trader can hedge this risk by selling government bonds short against his long positions in corporate bonds. In this way, the risk that remains is credit risk of the corporate bonds.
• an options trader may short shares in order to remain delta neutral so that he is not exposed to risk from price movements in the stocks that underlie his options

Arbitrage[link]

A short seller may be trying to benefit from market inefficiencies arising from the mispricing of certain products. Examples of this are

• An arbitrageur who buys long futures contracts on a US Treasury security, and sells short the underlying US Treasury security.

Against the box[link]

One variant of selling short involves a long position. "Selling short against the box" consists of holding a long position on which the shares have already risen, whereupon one then enters a short sell order for an equal amount of shares. The term box alludes to the days when a safe deposit box was used to store (long) shares. The purpose of this technique is to lock in paper profits on the long position without having to sell that position (and possibly incur taxes if said position has appreciated). Once the short position has been entered, it serves to balance the long position taken earlier. Thus, from that point in time, the profit is locked in (less brokerage fees and short financing costs), regardless of further fluctuations in the underlying share price. For example, one can ensure a profit in this way, while delaying sale until the subsequent tax year.

U.S. investors considering entering into a "short against the box" transaction should be aware of the tax consequences of this transaction. Unless certain conditions are met, the IRS deems a "short against the box" position to be a "constructive sale" of the long position, which is a taxable event. These conditions include a requirement that the short position be closed out within 30 days of the end of the year and that the investor must hold their long position, without entering into any hedging strategies, for a minimum of 60 days after the short position has been closed.^[27]

The regulatory response[link]

In the US, Regulation SHO was the SEC's first update to short selling restrictions since 1938. It established "locate" and "close-out" requirements^{[clarification needed]} for broker-dealers, in an effort to curb naked short selling. Compliance with the regulation began on January 3, 2005.^[28]

In the US, initial public offerings (IPOs) cannot be sold short for a month after they start trading. This mechanism is in place to ensure a degree of price stability during a company's initial trading period. However, some brokerages that specialize in penny stocks (referred to colloquially as bucket shops) have used the lack of short selling during this month to pump and dump thinly traded IPOs. Canada and other countries do allow selling IPOs (including U.S. IPOs) short.

In the UK, the Financial Services Authority had a moratorium on short selling 29 leading financial stocks, effective from 2300 GMT, 19 September 2008 until 16 January 2009.^[29]

After the ban was lifted, John McFall, chairman of the Treasury Select Committee, House of Commons, made clear in public statements and a letter to the FSA that he believed it ought to be extended.

In the US, a similar response was made by the Securities and Exchange Commission with a ban on short selling on 799 financial stocks from 19 September 2008 until 2 October 2008. Greater penalties for naked shorting, by mandating delivery of stocks at clearing time, were also introduced. Some state governors have been urging state pension bodies to refrain from lending stock for shorting purposes.^[30]

Soon thereafter, between 19 and 21 September 2008, Australia temporarily banned short selling,^[31] and later placed an indefinite ban on naked short selling.^[32] The ban on short selling was further extended for another 28 days on 21 October 2008.^[33] Germany, Ireland, Switzerland and Canada banned short selling leading financial stocks,^[34] and France, the Netherlands and Belgium banned naked short selling leading financial stocks.^[35]

By contrast, Chinese regulators have responded by allowing short selling, along with a package of other market reforms.^[36]

An assessment of the effect of a ban on short-selling that was enacted in many countries in the fall of 2008 showed that it had only "little impact" on the movements of stocks, with stock prices moving in the same way as they would have moved anyhow, but the ban reduced volume and liquidity.^[37] By December, countries in Europe were considering to remove the ban, while the ban in the US was already lifted in October 2008. The SEC proposed new restrictions on short selling in April 2009.

Views of short selling[link]

This section requires expansion.

Advocates of short selling argue that the practice is an essential part of the price discovery mechanism.^[38] Financial researchers at Duke University said in a study that short interest is an indicator of poor future stock performance (the self-fulfilling aspect) and that short sellers exploit market mistakes about firms' fundamentals.^[39]

Such noted investors as Seth Klarman and Warren Buffett have said that short sellers help the market. Klarman argued that short sellers are a useful counterweight to the widespread bullishness on Wall Street,^[40] while Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.^[41]

Shortseller James Chanos received widespread publicity when he was an early critic of the accounting practices of Enron Corp.^[42] Chanos responds to critics of short-selling by pointing to the critical role they played in identifying problems at Enron, Boston Market and other "financial disasters" over the years.^[43] In 2011, research oriented short sellers were widely acknowledged for exposing the China Stock Frauds.^[44]

Commentator Jim Cramer has expressed concern about short selling and started a petition calling for the reintroduction of the uptick rule.^[45] Books like Don't Blame the Shorts by Robert Sloan and Fubarnomics by Robert E. Wright suggest Cramer exaggerated the costs of short selling and underestimated the benefits, which may include the ex ante identification of asset bubbles.

Individual short sellers have been subject to criticism and even litigation. Manuel P. Asensio, for example, engaged in a lengthy legal battle with the pharmaceutical manufacturer Hemispherx Biopharma.^[46]

Several scientific results on the effectiveness of short selling bans indicate that short selling bans do not contribute to more moderate market dynamics.^{[47][48][49][50]}

See also[link]

• Inverse exchange-traded fund
• Joseph Parnes
• Long (finance)
• James Chanos
• Magnetar Capital
• Manuel P. Asensio
• Repurchase agreement
• Securities lending
• Short ratio
• Socially responsible investing
• Speculation
• Straddle
• Uptick rule
• Anthony Elgindy

References[link]

• Sloan, Robert. Don't Blame the Shorts: Why Short Sellers Are Always Blamed for Market Crashes and Why History Is Repeating Itself, (New York: McGraw-Hill Professional, 2009). ISBN 978-0-07-163686-5
• Wright, Robert E. Fubarnomics: A Lighthearted, Serious Look at America's Economic Ills, (Buffalo, N.Y.: Prometheus, 2010). ISBN 978-1-61614-191-2

External links and sources[link]

• Barron's on Off Wall Street Consulting Group, July 31, 2010
• Porsche VW Shortselling Scandal
• "Short-Selling Bans Dampen 130/30 Strategies Worldwide," Global Investment Technology, Sept. 29, 2008
• Short Selling Introduction
• Short Interest: What it tells us
• SEC Discussion of Naked Short Selling
• '"Financial Interest Disclosures Can Protect Markets from 'Short & Distort' Manipulators", Alex J. Pollock, June 6, 2006, Washington Legal Foundation
• Coverage of controversial short-selling 'conspiracy' lawsuits by tobacco litigation specialists in US: Short Tempers, Risk Magazine (2006), Navroz Patel
• In pursuit of the naked short, Journal of Law and Business, New York University, Spring 2009