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First, talk of banning shorting is both stupid and practically impossible. But naked shorting is a very different beast. Naked shorting seems to me an illegitimate variation on shorting and should have been consigned to the dustbin years ago. This is one of those regulatory questions that is actually quite straightforward: How can you short if you don't own the shares? It's a lot like the recent CSX case revolving around activist hedge funds voting shares in proxy contests they don't really own. As the judge in the CSX case decided, this is a practice the SEC should have already shut down. The same applies to naked shorting, which raises the question of why the SEC singled out 19 financial stocks to apply its 30-day, no-naked shorting ban, when it should have just banned the practice altogether? Second, why has the SEC acted so squirrelly on issues, like naked shorting or virtual voting, that offer little or no real economic benefit and that appear to be cheating? The first speculative answer is political: Both practices favor activist investors, and the SEC may have decided that politically, or in terms of governance, it's a good idea to be on the side of shareholders and, in this case, the prime brokers of Wall Street. Of course the SEC also seemed to spend a lot of time saying it's helping out corporations, a slipperiness that appears to be characteristic of the Cox era at the SEC. Maybe it figured these issues are so complex that no one will ever really care except a few professionals and opponents of the practice like Overstock.com's Patrick Byrne and his insurrectionists on the Web. The final observation is a scary one. Perhaps the SEC never moved on these practices because it knew it couldn't, that it lacked either the will or manpower or data to really crack down on instances of naked shorting or virtual voting. Maybe the agency figured it would keep an eye on the situation, making sure it didn't get out of hand, and always be ready to hammer someone if necessary (meaning: Congress was getting interested in the practice) as a warning. (Much of the debate swirling around Overstock and naked shorting was over how large and serious a problem it was: Byrne and his followers described it as a systemic threat, the SEC and Wall Street dismissed it as harmless -- not really kosher, mind you, just harmless. By not acting sooner, the SEC buttressed Byrnes' argument.) Of course, we never got to the hammering or the warning before the crisis occurred, and the SEC embraced naked shorting as if it was the key to our salvation. Naked shorting thus tells us more about the failures of the SEC than it does about what's really happening out there on those stormy seas. It defines regulatory incoherence. - Robert Teitelman CategoriesComments
From: Matt,
Krim's argument is unfortunately not very strong. If the debt securities lose liquidity and are priced at a premium, then maybe they ARE supposed to be priced at that premium. It is not about fragile banks going bankrupt - you can still short. Also, no one is snatching away any legitimate method of either expressing bearish sentiment on a stock or using stock performance as a hedge. Ultimately naked shorting is simple a way of gaming the inexplicable 'settlement period' - which is a glaring market inefficiency in this day and age of electronic trading and settlement. Shifting to instant electronic trade settlement would automatically eliminate 'naked shorting', thus making any argument for it moot.
Posted on:
July 22, 2008 6:26 PM
From: Matt,
Krim's argument is unfortunately not very strong. If the debt securities lose liquidity and are priced at a premium, then maybe they ARE supposed to be priced at that premium. It is not about fragile banks going bankrupt - you can still short. Also, no one is snatching away any legitimate method of either expressing bearish sentiment on a stock or using stock performance as a hedge. Ultimately naked shorting is simple a way of gaming the inexplicable 'settlement period' - which is a glaring market inefficiency in this day and age of electronic trading and settlement. Shifting to instant electronic trade settlement would automatically eliminate 'naked shorting', thus making any argument for it moot.
Posted on:
July 22, 2008 6:27 PM
From: Confused,
The poster asks "How can you short if you don't own the shares?" Huh? If you owned the shares you would be long, no? Then by definition it wouldn't be a short sale. "Naked shorting" -- a term often invoked but apparently little understood -- is when you sell short (i.e., sell shares you don't own but have borrowed or intend to borrow -- a practice that is and almost always has been completely legal) and then for some reason your broker can't deliver to settle on T+3. And even that failure to deliver is not per se illegal; it is only illegal if done in violation of Reg SHO (i.e., you never even made an effort to borrow) or as part of a scheme to manipulate the shares of the stock, which requires proving manipulative intent -- good luck proving that.
Posted on:
July 22, 2008 9:01 PM
From: aaron,
Let's say company X has 5M shares. Key players believe it will lose a contract that represents 70% of its revenue. They all decide to short on the same day (2M +2M + 3M) = 7M. At settlement there are 2M shares that can't be found because they don't exist. A reasonable fix would be to make short sellers find and claim the exact share they want to borrow and let only one short grab that share. This is reasonable, Wall St. would cry but fix their systems to quickly handle this. It is amazing the SEC and other reglators have been so toothless over the last 5 years. They need to step up and do their jobs.
Posted on:
July 23, 2008 11:17 AM
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For all I know, the Securities and Exchange Commission ban on naked shorting has saved the markets and Western Civilization, though financial stocks are again losing ground Tuesday on news of ugly earnings at Wachovia Corp. So maybe we haven't been saved. Nonetheless, after confessing that I don't have a clue about what is really driving the markets, a few comments on naked shorting and what it all means. 
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I disagree with your argument that naked shorting should be banned. In fact the market will not function without nakes shorting since there a plenty of debt securities out there than will loose liquidity if there is no way for traders to short stock against them. In normal times there might be enough real time borrow to execute convertible transactions or CDS trades, but in reality most of these transactions happen at times when traders need quick shorts to be able to look in their hedge. If their trading strategies depend on the ability of their prime broker to locate borrow instantly...well then there wont be much trading going on. The liqudiity in most of these debt instruments will go away and that is much worse than a few fragile investment banks going bancrupt. The SEC action was irresponsible and doesn't help anybody, not even the banks they are supposedly protecting.