Lawmakers are encouraging the Securities and Exchange Commission (SEC) to put some pants on naked shorts. Naked shorting is the practice of selling a stock that you don't actually have in your possession with the hope of buying it back after the price drops. This practice is already illegal, but enforcement is lax.
The Naked Basics
In a typical short sale, a trader borrows a stock from a brokerage firm's holdings and sells it to an investor with the hope of repurchasing the shares on the open market at a lower price in order to repay the borrowed shares and profit on the price difference. Naked short sellers make the sale without first borrowing the stock. If the trade clears before the seller can acquire shares, the short seller is unable to deliver the shares to the buyer. (To learn more, read The Short And Distort: Stock Manipulation In A Bear Market.)

Recent market turmoil has put naked trades in the spotlight. Consider, for example, the potential profits on selling shares in Lehman Brothers as the firm imploded. Traders selling shares they didn't actually own could reap incredible profits. In fact, the SEC temporarily banned naked short selling in 19 stocks for a brief period during the financial market meltdown, requiring traders to provide proof of ownership before they could sell one of these stocks short. (For more, check out Case Study: The Collapse of Lehman Brothers.)

Covering Up
Now, senators from both sides of the aisle are calling for traders to prove that they actually borrowed shares of a particular security before they can sell it short. The industry refers to the practice of having the shares before they can be sold as "pre-borrowing." While naked shorting is a sophisticated practice not commonly used by the average investor, one might expect that sophisticated buyers would be savvy enough not to buy something that they weren't sure the seller actually owned.

In fact, if you know anyone interested in purchasing the BrooklynBridge or some waterfront property in Florida sight unseen, there are a few traders prowling around Wall Street that can meet those needs. While it's a shame that sellers can't be trusted, the lessons of 2008 suggest that trust was sold short on Wall Street a long time ago and the sellers failed to deliver when the trade settled. (For more on this, read The 2007-08 Financial Crisis In Review.)

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