What is 'Naked Shorting'

Naked shorting is the illegal practice of short selling shares that have not been affirmatively determined to exist. Ordinarily, traders must borrow a stock, or determine that it can be borrowed, before they sell it short. Due to various loopholes in the rules, and discrepancies between paper and electronic trading systems, naked shorting continues to happen.

BREAKING DOWN 'Naked Shorting'

With naked shorting, an investor sells shorts associated with shares that they do not possess and have not confirmed their ability to possess. If the trade associated with the short needs to take place in order to fulfill the obligations of the position, the trade may fail to complete within the required clearing time because the seller does not actually have access to the share. The technique is seen as very high risk, regardless of its associated legal entanglements, but has the potential to yield high rewards.

While no exact system of measurement exists, most systems point to the level of trades that fail to deliver from the seller to the buyer within the mandatory three-day stock settlement period as evidence of naked shorting. Naked shorts may represent a major portion of these failed trades.

Naked Shorting and Liquidity

Naked shorting can affect the liquidity of a particular security within the marketplace. In cases in which a particular share is not readily available, naked short selling allows a person to participate within the associated activity even though they are unable to actually obtain a share. If additional investors become interested in the shares associated with the shorting, this can cause an increase in liquidity associated with the shares as demand within the marketplace increases.

Regulation Regarding Naked Shorting

The practice of naked short selling was banned within the United States in 2008 after the financial crisis of 2007/2008, as such activities contributed to the downward economic trend by allowing manipulators a chance to force stock prices down without regard for normal stock supply/demand patterns. The ban applies to naked shorting only and not to other short-selling activities.

In 2007, the Securities and Exchange Commission (SEC) amended Regulation SHO to further limit possibilities for naked shorting by removing loopholes that existed for some broker/dealers. Regulation SHO requires lists to be published that track stocks with unusually high trends in "fail to deliver" shares. Some analysts point to the fact that naked shorting, albeit inadvertently, may help markets stay in balance by allowing the negative sentiment to be reflected in certain stocks' prices.

Participants in naked illegal short selling activities can be charged with a crime based on the SEC regulations. In 2014, two Florida State University professors were charged with participating in the illegal practice that resulted in approximately $400,000 in revenue. Ultimately, the accused agreed to a settlement with the SEC in the amount of $670,000.

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