What is Naked Shorting?
Naked shorting is the form of short selling in which the seller doesn’t borrow the asset that he enters into a contract to sell, nor does he inquire whether such an asset can be borrowed or not, therefore it is a riskier proposition as compared to short selling because at the time of fulfillment of the contract, the asset might not be available and the contract might fail.
In a normal short sale, we follow the below procedure:
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 liquidity for a thinly traded stock in which the number of units available is very low. This is known as bonafide 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 short 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.
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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-Dealer 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 makers 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.
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 selling 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 debentures.
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.
- 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 illiquid 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.
- 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 crash in 2007-08.
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 –