Naked short selling

Naked short selling, or naked shorting, is the practice of short-selling a tradable asset without first borrowing the asset from another party or ensuring that it can be borrowed. When the seller does not obtain the asset and deliver it to the buyer within the required settlement period, the result is known as a "failure to deliver" (FTD). The transaction generally remains open until the asset is acquired and delivered by the seller, or the seller's broker settles the trade on their behalf.

Short selling is typically used to take advantage of arbitrage opportunities or to anticipate a price decline, but it exposes the seller to unlimited risk if the price rises instead.

Critics have long called for stricter regulations of naked short selling. In the United States, the Securities and Exchange Commission (SEC) adopted "Regulation SHO" in 2005, requiring broker-dealers to have a reasonable belief that a borrowed security will be available before executing a short sale, and mandating timely delivery of shares.

In July 2008, amid escalating financial instability, the SEC issued a temporary order restricting short sales of shares in 19 systemically important financial institutions, strengthening penalties for failures to deliver. On September 18, following the collapse of Lehman Brothers, these restrictions were extended to all U.S. listed companies, including market makers. Later that year, the SEC formally banned what it called "abusive" naked short selling, although naked shorting itself remains not per se illegal under certain technical circumstances, such as bona fide market making activities.

In August 2008, the SEC issued a temporary order restricting short-selling in the shares of 19 financial firms deemed systemically important, by reinforcing the penalties for failing to deliver the shares in time. Effective September 18, amid claims that aggressive short selling had played a role in the failure of financial giant Lehman Brothers, the SEC extended and expanded the rules to remove exceptions and to cover all companies, including market makers.

A 2014 peer-reviewed study by researchers at the University at Buffalo, published in the Journal of Financial Economics, concluded that failures to deliver did not cause price distortions or financial firms' failures during the 2008 financial crisis. Instead the authors found the larger FTDs increased liquidity and pricing efficiency, with effects comparable to those of conventional short sales".

Despite regulations, some market commentators have argued that naked shorting remains widespread and that enforcement of SEC rules is weak. Critics contended that the practice can be abused to manipulate stock prices, damage companies' ability to raise capital, and contribute to bankruptcies. Conversely, opponents of stricter regulation argue that concerns of naked shorting are overstated, describing them as a "devil theory", and an inefficient use of regulatory resources.