Naked Short Selling - An Introduction

Imagine an Asset that can be created from thin air, cost nothing to produce, can be created in unlimited quantities, can be easily sold with the push of a button for big money and the seller keeps all the money, forever.  Does this sound like an ideal way to make a lot of money?  Does this sound illegal?  As a matter of fact it is!

Welcome to the world of Naked Short Selling. 

Without getting into the basics or the ethics of Short Selling, I'll just say that it is a common practice in most financial markets.  In essence, the "Short Seller" is betting the price will go down (i.e. They Sell first and Buy back later).  This is usually perfectly legal although it can be risky.  (For detailed information go here:  http://en.wikipedia.org/wiki/Naked_short_selling ).    However, before you can understand the crime, first you need to understand some distinctions:

With Futures and Options: 

1. You are buying and selling a legal Contract (with specific rights and obligations).
2. These Contracts are created at will between the buyers and the sellers (by design).
   
3. They (either the clearing house or the exchange) keeps track of the Open Interest (number of Contracts outstanding).
   
4. There is a time limit (expiration date), when everything needs to be settled.
   
5. There is a clearing house to hold the trader legally accountable to the terms of their Contract(s).
6. There is a mechanism to take money out or put money into your account on a nightly basis (futures) or at expiration (options).
7. To short a Futures or Option Contract, all you need to do is push a button.  This is perfectly legal and by design.
8. To close the position, you simply hit the Buy button or wait for expiration.
   

With Stocks:

1. You are Buying and Selling an Asset.  (Representing a fraction of a corporation or a limited partnership etc.).
   
2. The number of shares outstanding is controlled by the corporation.
3. There is no time limit.  You could hold your IBM shares for 20 years.
   
4. Stock trades are typically settled in three days (US).  Money changes hands and so do the stock shares.
   
5. To Short a share of stock, you must first "borrow" the stock from someone else and then sell the stock.
6. To close the position, you simply hit the Buy button (which then theoretically returns the shares to the lender).
   

Naked Short Selling ONLY occurs on Stocks (or other Assets), not on Futures or Options contracts.  Stocks are supposed to be a limited in number.  There are mechanisms in place, in the securities market, to prevent shorting a stock which cannot be borrowed.  For the average investor, if there are no shares available to borrow, you simply cannot short it.  This ensures that the number of shares outstanding remains constant. 

However, the 'big boys' play by a different set of rules.  There are certain legal exemptions for certain market participants (market makers etc) and there is also a lack of SEC enforcement against other market participants.  They can short the stock which they have not yet borrowed as long as they promise to deliver the borrowed shares in before settlement (three days).   Sometimes they don't deliver.

Think of the implications of this practice (especially if this behavior is performed by criminals and/or psychopaths):

1. They are creating new shares out of thin air (which are supposed to be a limited Asset)
2. They sell them to unsuspecting buyers who think they have a real Asset in their account. 
3. Nobody knows who did it.
   
4. The Buyer may not know about the fraud for many years (or ever).   All the Buyer ever knows is that the price keeps going down.
   
5. If they create and sell enough shares they can drive the stock price down to $0 (and then they never have to buy it back !). 

Over the last decade, there have been a number of government attempts to curb the practice.  Not necessarily because it is outright fraud, but because it lowers the 'confidence' in our financial markets.  They held hearings and passed some new rules.  For example, if the shares are not delivered when they are supposed to, a report needs to be submitted to the SEC.   They have also removed some of the legal exemptions.  However, there still appears to be some exempt 'legal' naked short selling and the illegal and abusive naked short selling.  

Does Illegal Naked Short Selling occur today? Probably yes, but I am no expert in these things just an outside observer.   So, just out of curiosity, I picked up a few stock tickers from the NYSE website which had "Failure to Deliver" reports  (http://www1.nyse.com/regulation/memberorganizations/Threshold_Securities.shtml ) and viewed their price charts. 

Here are a couple of stocks which are appear to be diving relentlessly into the ground: END, USU, WLT.  I cannot tell if these stocks are dropping because of their deteriorating business conditions or due to naked short selling. But it is interesting that they are all dropping fairly consistently for three years straight.  (Keep in mind there MUST be bounces along the way in order to trick more victims into thinking the bottom is in and therefore commit to buying some/more shares).

WARNING:  I WOULD NOT BUY OR SHORT THESE STOCKS.  This is not investment advice, just a bit of education on some of the dirty ticks you need to know about in order to protect yourself.