Naked Short Selling: Definition, How it Works and Why is it illegal?

Naked short selling of financial instruments is the practice of short-selling assets without borrowing the assets first. Naked short selling leads to FTD(Failure To Deliver) when the seller is unable to gather securities for the buyer. FTD transactions remain incomplete until the seller gets the assets or the broker settles the transaction on its behalf.

The stock trader has to borrow or determine that it can be borrowed before selling the shares in ordinary cases. Naked short selling has a higher potential to affect the liquidity of the securities in the marketplace.

The oldest occurrence of naked short selling was registered in 1609. Which was executed by the Dutch trader Isaac Le Maire against the Dutch East India Company. Naked short selling continues to operate because of the loopholes in the rules and regulations formed by the concerned authorities, even though the practice of naked short selling was banned during the 2008 financial crisis. 

What is Naked Short Selling?

Naked short selling is a method of selling a short stock without borrowing it first or even confirming its existence. This method is considered an illegal method of short-selling. Naked short selling is also known as naked shorting. The assets involved are not borrowed first and also no confirmation of borrowing is made before selling.

Even today there is no exact system to identify naked short selling precisely, some of the systems consider failed trades as a shred of evidence for naked shorting. The majority of the failed trades are a result of naked shorting. Naked shorting disturbs the liquidity balance of the market as the traded shares are not available in the market. 

How does Naked Short Selling work?

Naked short selling is a special case of short selling in which the trader does not arrange to borrow the shares first. When the availability of the stock is limited, it becomes difficult for the seller to give them to the buyer. This can happen due to various reasons the lenders of the stock are not available, or the cost of stocks is too high for the short seller.

In such scenarios, when the shares are not transferred within the clearing time(generally 3 days), the trade is considered FTD(Failed To Deliver). The trade remains open until it is settled by the short seller or the broker. It is difficult to spot naked shorting in a market, as there is no clear evidence related to it.

What are examples of Naked Short Selling?

Examples of naked short selling come to light when it works well or when it doesn’t.

In 2014, two professors at Florida State University were caught using strategies of naked shorting on 20 companies. They made around $400,000 during that whole process.

As per the Securities and Exchange Commission of the United States, naked short selling is illegal and anyone involved in doing so would be punishable. The rules and regulations regarding naked shorting became stricter after the 2008 financial crisis. In 2008, there was high speculation about cannabis naked shorting. In the cannabis industry, naked shorting was common, since shares were scarce and in high demand, but short interest grew despite this.

A famous example of short selling is the Game Stop example. Short sales include institutional investors borrowing GameStop shares and then selling them. If the stock price follows their forecast, they may repurchase it later and pocket the difference. On Wall Street, GameStop is among the most shorted companies. 

Minority investors, however, were not amenable. Together, they pushed GameStop’s stock price to unprecedented heights. 

Known as a short squeeze, this situation is the consequence of smaller investors urging each other to acquire GameStop shares on Reddit and other discussion forums. 

Discussions on the Reddit community “Wall Street Bets” are often full of self-deprecation, gratitude for luck, and ideas for the next great move to get in on. 

Recently, they’ve been urging one another to keep purchasing GameStop in order to take it “to the moon.” 

A few days after, GameStop’s stock was trading at roughly $18 per share; in the subsequent four days, its worth quadrupled. After almost doubling on the next Monday, it more than doubled again on Tuesday, and it reached $347.51 on Wednesday. As on Thursday, it recouped some of its losses by closing at $193.60, down 44% from its previous high. By the first few weeks of 2021, it had increased by a still remarkable 928%.

Why is Naked Short Selling illegal?

Naked short selling involves selling securities without borrowing them first, creating liquidity issues in the market. The main aim behind naked shorting is to exploit arbitrage opportunities or to predict a price fall. For example in 2007 the Securities and Exchange Commission(SEC) fined $2 million for giving its customers the advantage of shorting shares before the second public offering.

In certain cases, failing to deliver shares to the buyer is considered legal, but in the case of naked shorting, it’s a completely illegal and punishable offence. As per a few studies, naked short selling had a major role in the fall of the Lehman Brothers, which triggered the 2008 financial crisis. So to limit such activities in future the SEC made regulations completely removing exceptions and extended the law covering all companies. 

Is Naked Short Selling banned in the U.S.?

Yes, naked short selling is considered illegal in the United States and is banned under the regulations of the SEC. The first partial restriction to naked short selling was implemented in 1938. Later in 2005, “Regulation SHO” was implemented which made sure that delivery occurs within a certain time frame and that broker-dealers have a specific reason to think that shares will be accessible for a specific stock transaction.

In 2008, around 800 financial stocks were banned because of naked short selling and also penalties were introduced depending upon the clearing time.

Which agency is in charge of regulating Naked Short Selling in the U.S Stock Market?

The Securities and Exchange Commission (SEC) is responsible for regulating naked short selling in the U.S. stock market. After the events of the 2008 financial crisis, the SEC placed limitations on extreme short-sale transactions. The SEC is an independent body of the federal government responsible for maintaining fair trade in the stock market. It was started in 1934, as the first stock market regulator of the United States.

It is responsible for making and implementing all the laws protecting investors’ rights. The SEC considers naked short selling as illegal as it creates a liquidity imbalance in the marketplace. This imbalance is created by the stocks that are not even available in the market. Hence to stop such kinds of manipulations SEC makes sure that naked short-selling is prohibited.

Is Naked Short Selling banned in India?

Yes, naked short-selling is considered illegal in India. As per the Securities and Exchange Board of India (SEBI), naked short is strictly restricted in the Indian markets and all the investors involved in the trade should mandatorily deliver their securities during the time of settlement. Although the Indian stock exchanges allow short selling to retail as well as institutional investors.

Which agency is in charge of regulating Naked Short Selling in the India Stock Market?

The Securities and Exchange Board of India (SEBI) is responsible for dealing with naked short selling. In 2001, SEBI  temporarily banned short selling due to the Ketan Parekh case of stock market manipulation. But afterwards, it reintroduced short selling with limitations similar to the U.S. stock market.

In March 2007, SEBI also prohibited naked short selling in the Indian markets to protect the investor’s rights and avoid any kind of market manipulation.

What is the advantage of Naked Short Selling?

Some market analysts are in favor of naked short selling, they believe that the ban against naked shorting should be removed. 

• They contend that when a stock has low liquidity and a small number of shares are available to be borrowed from a broker and sold short, naked shorting can be useful in identifying the true value of a stock in the market.
• Naked shorting also saves time and effort, as in the case of normal shorting the trader has to borrow the security. But in the case of naked shorting the trader does not ensure borrowing the shares before selling.
• Naked shorting also saves the cost of borrowing the securities, just because the trader is not borrowing the securities for the trade.

What is the disadvantage of Naked Short Selling?

Even though it is prohibited, naked shorting nevertheless happens in the current market, and regulators keep a close eye out for any possible illicit conduct. Some of the major disadvantages of naked short selling include:

• Naked short selling is considered illegal in most of the major stock exchanges of the world 
• This promotes stock market manipulation as does not take into account the factors of demand and supply
• Naked short selling increases the volatility in the stock market, this ultimately reduces the trust of the investors in the market

What is the difference between Naked Short Selling and Short Selling?

• Short selling involves selling securities before buying them, in this, the investors borrow the securities to sell them later. But in case of naked short selling, the securities are sold with having the provisions to borrow the securities.
• The transactions are successfully settled during the settlement period in short selling. But in naked shorting the transactions are failed and remain open because of no settlement of shares by the trader.
• Short selling is completely legal in all of the stock exchanges in the world. Naked short selling is considered illegal in most of the major stock exchanges because of its use in the manipulation of the stock market.