What is Naked Short Selling?
Naked short selling refers to the now-illegal practice of shorting shares without first borrowing the assets or making sure that they actually exist.
You’ve likely heard about short selling recently in relation to Gamestop and AMC and the alleged market manipulation by Reddit investors to throw a wrench in Wall Street’s plans for profit.
For those of you who need a refresher, short selling typically refers to when a trader profits off of a loss in stock price. That obviously sounds counter intuitive, but traders can borrow and immediately sell shares at a high price and later buy them back at a lower price in order to return the shares to the original owner.
Borrow and sell high, buy and return low.
Source: Stock Market & Forex Blog
WHAT’S THE DIFFERENCE?
Typical short selling and naked short selling differ in one key way: the borrowing ‘step.’ Traders will typically borrow the shares they wish to short. Naked short sellers go straight to selling shares they don’t own inany capacity.
The Zero Theft Movement, along with our community, is striving to eliminate the rigged parts of the U.S. economy. Naked shorting, while illegal, has perhaps received undue criticism especially due to its connection to the 2008 financial crisis. We want to eradicate the economic practices that actually give unfair advantages to a privileged class or group. In this article, we will examine how naked short selling might not present the problems commonly associated with it.
The Naked Shorting Process
In essence, naked shorting selling involves traders selling assets they don’t actually have or might not even exist. It presents a huge financial (and legal) risk that does come with the potential to generate commensurate rewards.
Let’s take a closer look at a simple example to illustrate how naked shorting looks.
A trader sells short 1,000 shares of Stock X without receiving approval for margin trading. That approval is necessary if they wish to borrow the shares from their broker.The trader hopes for a quick decline in the stock price, so that they can close out their short sale with a purchase of 1,000 shares at a lower market price.
Earning a profit on the short sale and delivering the shares to the buyer becomes a race against time. The Securities and Exchange Commission (SEC) has a mandatory securities settlement period in place, where sellers must deliver assets to buyers within two days. If buyers do not receive the assets in time, it results in a ‘failure to deliver’ and a cancellation of the transaction.
Thus, the short seller hopes (1) the stock price will drop considerably before the settlement period ends and (2) they actually get the requisite shares to deliver to the buyer.
The Savings and Loan Crisis in the 70s resulted in the failure of nearly a third of 3,234 S&Ls and reportedly cost taxpayers $132 billion. Was economic foul play involved?
The Contested Impacts of Naked Short Selling
Naked shorting requires speculative trading without actual ownership of the shares or approval. In traditional short selling, traders actually borrow the shares. That exposes them to the risk of the stock prices rising, not just cancelled transactions. Critics claim the practice can severely impact liquidity of a security on the stock market, leading to major price fluctuations and the bankruptcy of companies.
Former SEC Chairman Christian Cox, in a commission open meeting in 2006, stated: “The next item on our agenda is the serious problem of abusive naked short sales, which can be used as a tool to drive down a company’s stock price to the detriment of all of its investors.”
Some doubt the naked short selling has much of an effect on the stock market, and others even argue that it creates positive outcomes. Naked shorting can unintentionally help balance markets because it allows negative sentiment to immediately be reflected in stock prices. The engineered drop in prices can encourage other participants to unload dipping stocks, cutting their losses early and bringing balance to the market.
Naked Shorting in the 2008 Subprime Mortgage Crisis?
A narrative emerged between regulators from the SEC, commentators in the media, and Wall Street executives that naked short selling had caused the collapse of two ‘too big to fail’ investment banks in Lehman Brothers and Bear Stearns, as well as the 2008 financial crisis.
Source: Market Watch
Matt Taibbi, a contributor editor for Rolling Stone, penned an article discussing how naked shorting contributed to each company’s precipitous fall. Taibbi claims: “Like all the great merchants of the bubble economy, Bear and Lehman were leveraged to the hilt and vulnerable to collapse. Many of the methods that outsiders used to knock them over were mostly legal: Credit markers were pulled, rumors were spread through the media, and legitimate short-sellers pressured the stock price down. But when Bear and Lehman made their final leap off the cliff of history, both undeniably got a push—especially in the form of a flat-out counterfeiting scheme called naked short-selling.”
Academic research appears to support this viewpoint for the most part, although Taibbi may have overstated the impact of naked short selling. Professors Veljko Fotak, Vikas Raman, Pradeep K. Yadav published a 2010 study claiming: “We…investigate[d] naked shorting around the demise of financial firms hardest hit by the 2008 financial crisis and f[ound] no evidence that their price-declines were caused by naked shorting. We also f[ound[ that naked shorting intensifies after rather than before credit downgrade announcements or large price declines. In general, naked short sellers respond to public news and price declines rather than trigger them. Finally, we f[ound] that manipulative naked shorting during our 2008 financial crisis sample period was not different from pre-crisis 2007 levels, and significantly lower than what it was prior to Regulation SHO.”
Leverage > Naked Shorting
Source: Farcaster via Wikimedia Commons
Rather than deflecting the blame from investment banks, many believe their questionable business practices involving extremely high-risk investments and mountains of leverage should remain the focus.
Regulators failed to properly address the dangerous investing leading up to the financial crisis and did not recognize the alleged coverup jobs Lehman Brothers and Bear Stearns might have carried out for years.
For more on the Leham Brothers case, Professor Agatha E. Jeffers wrote the following paper, which examines how the company allegedly utilized the repo market to “manipulate their financial statements.”
As it pertains to Bear Stearns, the SEC published a press release detailing the allegations and charges against two of the company’s hedge fund managers. According to the SEC, they “fraudulently [misled] investors about the financial state of the firm’s two largest hedge funds and their exposure to subprime mortgage-backed securities before the collapse of the funds in June 2007…caus[ing] investor losses of approximately $1.8 billion.”
The subprime mortgage crisis has reportedly cost upwards of $20 trillion, per a Better Markets report. Do you think investment banks knowingly took on way too much risk to boost their profits at all costs? Did regulators fail the public?
Current Regulations Against Naked Short Selling
As mentioned in the introduction, naked shorting is illegal. Regulators have taken a hardline stance against the practice, likely due to its (tenuous) connection to the subprime mortgage crisis. Public sentiment, as well as the narrative overstating the impacts of naked shorting, likely compelled regulators to take action.
Thus, the SEC included prohibitions against the practice in the Dodd-Frank Wall Street and Consumer Protection Act of 2010. Congress passed the legislation in order to address the blindspots and loopholes that had led to the complete collapse of the U.S. economy.
In fact, the SEC had first attempted to limit the practice prior to the Dodd-Frank Act. But then and even now, regulations have been supposedly ineffective and unenforced.
Potential Cases of Naked Short Selling
The Wolfson Brothers
On January 31, 2012, the SEC announced it had charged two brothers with “naked short selling for failing to locate and deliver shares involved in short sales to broker-dealers.”
The press release (linked above) states: “Jeffrey A. Wolfson and Robert A. Wolfson, they generated more than $17 million in ill-gotten gains from naked short selling transactions involving such stocks as Chipotle Mexican Grill Inc., Fairfax Financial Holdings Ltd., Novastar Financial Inc., and NYSE Group. As Jeffrey Wolfson stated in a recorded telephone conversation, ‘What I sell them is not guaranteed, it never gets delivered, it’s funny paper.’”
Goldman Sachs
In 2010, USA Today released a report claiming Goldman Sachs had “agreed to pay $450,000 to settle regulators’ allegations that it had violated a rule related to short-selling of stocks in 2008-2009.”
According to the article, “NYSE Regulation said a hearing officer had found that from early December 2008 to mid-January 2009, Goldman Sachs Execution & Clearing failed on ‘approximately’ 68 occasions to close out in time fail-to-deliver positions in stocks. The firm also ‘failed to reasonably supervise and implement adequate controls’ to ensure compliance with the short-selling rule, NYSE Regulation said.”
The previously quoted Rolling Stone editor Matt Taibbi wrote another article on naked short selling. This one focuses more on Wall Street’s alleged culture of disregarding the SEC’s rules. He writes: “More damning is an email from a Goldman, Sachs hedge fund client, who remarked that when wanting to ‘short an impossible name and fully expecting not to receive it’ he would then be ‘shocked to learn that [Goldman’s representative] could get it for us.’ Meaning: when an experienced hedge funder wanted to trade a very hard-to-find stock, he was continually surprised to find that Goldman, magically, could locate the stock. Obviously, it is not hard to locate a stock if you’re just saying you located it, without really doing it.”
Florida State University Professors
On January 31, 2014, Reuters reported that two Florida State University professors specializing in financial markets and physics respectively paid more than “$670,000 to settle civil charges that they carried out an illegal short-selling scheme using an elaborate options strategy…”
The article goes on to state that “The SEC said the pair of researchers illegally reaped $420,000 through a complicated ‘naked’ short-selling strategy in 20 different companies, including Sears Holding Corp and LinkedIn, among others.”
Does Naked Shorting Contribute to the Rigged Economy?
While the SEC treats naked shorting a white-collar crime, the practice may not actually cause the financial damage one might think. In fact, it could actually help balance markets so they more accurately reflect public sentiment.
But maybe you have found or know some important evidence that we’ve missed. Does naked shorting allow certain traders to gain undue advantages to a material degree?
Regardless, the problem of the rigged economy includes but extends far beyond this practice. Crony capitalists and corrupt corporations could be gaming markets throughout the economy by breaking laws and/or influencing legislation and regulation through lobbying. The extreme leverage allegedly encouraged and rewarded by Wall Street companies leading up to the 2008 financial crisis represents one example of how bad actors might have unethically profited off the public.
We at the Zero Theft Movement are working to achieve economic justice by holding Congress accountable with facts and evidence. On our independent voting platform, our community collaborates to calculate the best estimate for the monetary costs of corruption in the U.S.
Citizens investigators research potential cases of ‘theft’ (unethical, not necessarily illegal, actions that have ripped off the public) and author proposals. The community votes on whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Many ethical businesses and corporate executives exist. The Zero Theft Movement just wants to eliminate the ill-gotten gains that should be going directly to citizens or indirectly to them through proper, high-quality government services.
Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.