Turning up the heat on naked shorting

US authorities are worried about naked shorting: it's aggressive and can attract shady characters. But others find it a useful strategy. So what's the truth behind the concerns?

What is naked shorting?

Naked shorting might sound like one of the more louche responses to the heatwave, but in fact it's a particularly aggressive (and legally dubious) form of short-selling. Normally, short-sellers sell borrowed shares with the intention of buying them back at a lower price to return to the lender. The difference is pocketed as profit. In naked shorting, a trader shorts a stock without first making the necessary arrangements to borrow shares.

The result is that sometimes the seller fails to deliver the stock to the buyer and the trade can't be settled. It's an activity frowned upon almost everywhere and one that is increasingly exercising the minds of the US authorities. This week, the New York Stock Exchange levied $1.5m in fines on Goldman Sachs, Citigroup, Credit Suisse and Daiwa Securities following a short-selling investigation.

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Does this mean that short-selling is bad?

No, although lots of people don't like it particularly shareholders and executives of firms who come under attack from short-sellers. But as former SEC chairman Harvey Pitt observes on Forbes.com, short-selling has its uses. It offers essential liquidity in thinly traded stocks, allows traders to limit the degree of risk to which their portfolio holdings are subject and helps offset the herd mentality that is all too often demonstrated by many analysts and investors. The caveat? Short-selling has to be done properly to fulfil these functions. Short-sellers are marketplace lone wolves or, more precisely, lone bears, who trade against conventional wisdom and often lead the pack in exposing real corporate frauds. On the other hand, some companies are victimised by professional short-sellers using dubious means to help their bearish gambles succeed. These include aggressive naked shorting.

So why would anyone want to naked short?

Saving money is one major reason, explains Edward Chancellor of Breakingviews.com. US law requires the short-seller to borrow the stock before trading. Stocklenders charge for this service, making it expensive when everyone wants to short the same stock and it's in limited supply.

But there is a more sinister reason. Naked shorting is "normally associated with shady characters who engage in bear raids on penny stocks". Their aim is to destroy market confidence in the target firm. Patrick Byrne, CEO of troubled online retailer Overstock.com, has been leading a crusade against naked shorting in the US, claiming that it can put vulnerable firms out of business. (Others say that his firm's declining share price is more to do with weak results than any naked shorting conspiracy.) Another possible incentive for naked shorting cropped up in an ongoing lawsuit by two US hedge funds against their brokers: the funds claim that when they shorted stock, the brokers charged them for stock loans but carried out a naked short and pocketed the fees (the brokers deny any wrong-doing).

What are the authorities doing to tackle naked shorting?

The US Securities and Exchange Commission regards most forms of naked shorting as illegal. Around 18 months ago it tightened the rules by introducing Regulation SHO (this week's fines were the first time it was applied). Among its requirements are that short-sellers and their brokers must have reasonable grounds to believe securities being sold short can be "borrowed so that [they] can be delivered at settlement". However, there is no consensus of opinion on what constitutes "reasonable grounds", says Pitt. There have also been complaints most vociferously from companies claiming to be victims of naked shorting and class-action firms representing them that SHO doesn't apply to so-called failures to deliver that occurred before its introduction. The SEC now proposes to remove this exemption. SHO also permit market makers legally to naked short shares to facilitate their clients' trades, in the course of their market making activities. Failures to deliver inevitably result, so the SEC seeks to tighten up this exemption too.

Just how serious is the problem?

It depends on who you ask. The Byrne camp claims that naked shorting not only supports the bear raids that destroy companies, but also creates "phantom shares", with investors believing they own stocks that turn out to be non-existent. Along with other doomsayers, they predict the financial system will tumble once this is exposed. But most are sceptical of the wilder conspiracy theories. Although short-selling is a problem, there's scant evidence that it is "part of a co-ordinated scheme involving brokers, media, and regulators trying to bring down targeted companies", says Karl Thiel of The Motley Fool. In numerical terms, the SEC says that the new SHO regulations have cut failures to deliver by around 20%. They still amount to around $3bn a day, but not all failures necessarily result from naked shorting.

Is there more to come?

You bet, says Chancellor. The SEC's proposals don't address the latest hot topic the possible involvement of leading investment banks in the naked shorting affair. The courts will decide on this. Eliot Spitzer is doubtless waiting in the wings to see "whether he can make political capital from another assault on Wall Street's miscreants". Pitt agrees. The problems threaten to "kill off the goose that is laying very golden eggs". If the

securities industry and clearing firms fail to act quickly to make stock lending and borrowing altogether more transparent, the result will be that they can expect much tighter regulation.

by Graham Buck