What is Naked Shorting?

Explanation

In a normal short sale, we follow the below procedure:

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Naked Shorting (wallstreetmojo.com)

Basically, the trader or the borrower of the asset expects the price of the asset to go down in the market, and therefore he will be able to sell high and buy low later to return the asset to its owner. The price difference between the sale and purchase of the asset is the profit of the trader.

Now naked shorting refers to a situation where step 1 of borrowing the asset is not done. The trader enters into a contract of delivering the asset to the buyer at a predetermined later date and expects that in the meantime, he will be able to buy the asset from the market at a lower price and fulfill the sale contract. This leads to a risk of not being able to buy the asset and, therefore, that of not delivering it to the buyer.

Purpose of Naked Shorting

The main aim of this type of shorting is to generate liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more for a thinly traded stock in which the number of units available is very low. This is known as bona fide market-making activity in which the brokers and dealers exchange such contracts on a continuous basis to generate interest in the stock.

At times the lack of liquidity makes it extremely difficult to enter into a covered shortCovered ShortShort covering refers to buying already sold security which is borrowed in anticipation of a fall in price to cover the short position. A Short position is created by short-selling or selling of security initially borrowed with the expectation of buying at a lower price.read more position for the asset to be shorted. Therefore the traders enter into a naked position to not bear the high borrowing costs and straight away purchase the asset at the time of delivery.

Rules of Naked Shorting

As per the new rules released by the Securities Exchange Commission (SEC) on September 17, 2008, for increasing investor protection, the following actions were taken to prevent ‘abusive’ naked short selling:

  • The contract should be settled, and the shorted asset should be delivered on T+3 days from the date of the sale transaction.Any delay or failure in meeting the above settlement condition would attract a penalty.Further, the Broker-DealerBroker-DealerA broker-dealer is a person or company that trades and executes financial securities, stocks, commodities, or derivatives for itself or on behalf of its customers, for which it charges a commission as its main source of income.read more of the seller will be banned from shorting the same asset in all future transactions until and unless it is a covered short sale.This ban would be imposed for the transactions that this broker and dealer would want to enter into with any and every seller and not just for the seller who had failed to deliver.Earlier, the option market makersMarket MakersMarket makers are the financial institution and investment banks which ensures enough amount of liquidity in the market by maintaining enough trading volume in the market so that trading can be done without any problem.read more were exempted from the closing out regulation under Rule 203(b)(3) in the regulation SHO. However, after the above rule came into effect, they were also included for the same treatment as all other market participants.Further, an anti-fraud rule 10b-21was adopted to take care of sellers with fraudulent or deceptive intentions to protect the brokers and dealers.

Effects

The effect of this strategy can be understood through the following chain of events:

As explained above, once the brokers and dealers initiate buying and selling of less liquid stock, other investors get interested in it and start demanding the same. This leads to greater liquidity as it becomes easier to find buyers and sellers for the stock.

It may appear like market manipulation; however, it can also be perceived as a sales promotion or a marketing activity to create a buzz around a new product. Once the demand is generated, the investors undertake due diligence before buying and selling particular security, and therefore, till the time it is not impacting the price, it is a justified effort to garner interest.

How Does it Work?

Promise to deliver is made at a higher price because the seller expects that on or before the time of delivery, the price of the asset will fall. If this actually happens, then the purchase of the asset takes place at a lower price. After the delivery of the asset, the difference between the two prices less the transaction costs, if any, becomes the profit for the seller.

Example of Naked Shorting

One of the real-life examples of naked shorting could be the case of SEC v. Rhino Advisors Inc. and Thomas Badian, February 26, 2003. In this case, Rhino advisors worked on behalf of Sedona Inc and on the instructions of their president, Thomas Badian, entered into short sellingShort SellingShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen.read more contracts, where the underlying were the stock in which the convertible debentures of the company would be converted if and when the debenture holder exercised his right to convert the debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more.

Here these stocks didn’t exist at the time of the short-selling and, therefore, could come under the domain of naked shorting. This led to the suppression of prices for Sedona stocks and eventually forced the debenture holder to convert his holdings into stock.SEC imposed a penalty of $1 million on Rhino Advisors in this case.

Difference between Naked Shorting and Short Selling

  • Borrowing: Under short selling, the asset is borrowed while in naked shorting, it is not.Regulation: Short selling is regulated but not banned in the US. Naked short selling faces greater regulations and is almost as good as banned because the regulations make such strategies deem to be like short selling only as they require proper due diligence as to the availability of the asset.

Benefits

  • Reduces Time and Effort: Through this strategy, the time that goes into borrowing or finding out whether the security can be borrowed is saved. It is effectively postponing this effort to the time when the actual fulfillment of the contract is required.Bringing Liquidity: As explained in the previous sections, it helps in increasing liquidity of relatively illiquidIlliquidIlliquid refers to an asset that cannot be converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. Bonds, stocks and properties are some examples of illiquid investment.read more security.Checks the Cost of Borrowing: If the cost of borrowing the security is exorbitant, then this enables the traders to avoid such costs, and due to lack of demand for borrowing it, the borrowing costs face correction and reduce to an affordable level.

Limitations

  • Market Manipulation: One of the biggest disadvantages of this strategy is that it leads to unjustified selling pressure on security, which reduces its price to an unjustified level. This is what is known as ‘abusive’ naked shorting, and this is the practice that is banned by the SEC. However, it is hard to identify which of the sales are abusive and which aren’t.Fail to Deliver: If this strategy is allowed to continue freely, it may lead to failure of the seller to deliver the asset to the buyer at the time of delivery because the asset actually doesn’t exist and this is one of its biggest limitations, which led to its ban post the stock market crashThe Stock Market CrashA stock market crash occurs when stock prices in all sectors begin to fall rapidly. It is often the result of global factors such as war, scam, or the collapse of a certain industry. In such a crash, panic acts as a catalyst.read more in 2007-08.

Conclusion

To sum up, we can now understand that naked shorting is a strategy used to sell the asset, which is neither owned nor borrowed and is purchased at a later date to fulfill the delivery of the same to the buyer. It is a variation of short selling; however, the latter uses a borrowed asset to fulfill the strategy. Post-2007-08 crisis, the SEC made very strict regulations to curb this practice, and later it effectively banned the same to avoid abuse of the strategy that led to market manipulation.

This has been a guide to What is Naked Shorting and its definition. Here we discuss the rules and effects of Naked shorting along with their example, Benefits, Limitations. You can learn more from the following finance articles –

  • Short Position MeaningShort Sale of StocksShort Sale vs. ForeclosureMarket Timing Definition