05 Oct 2008

Revision of My Views on Naked Shorting

All Posts No Comments

In August I wrote a piece for Mises.org that lambasted the SEC’s move to ban “naked” short selling of a few financial stocks. I argued that it was a pointless gesture and served only to soften up the public for greater restrictions. Looking back, I think I nailed it on this score.

However, in the article I also came off as saying that there was nothing wrong with naked shorting. But since writing, I have received a lot of negative feedback from people who seem to know what they are talking about. For example, they are telling me that when some companies vote on things, there are way more votes cast than shares exist, because of the naked shorts.

Here is an excerpt from my August article, with the crucial part in bold:

Some of the commentary on naked short selling has become downright silly. The naked short seller is not violating the laws of logic; certain bloggers write as if we should fear a rip in the space-time continuum centered on Wall Street. If a particular stock is illiquid, and a trader wishes to speculate on an anticipated hourly move in the share price, nothing is harmed by allowing him to sell 1,000 shares and then buy them back 45 minutes later; the broker can simply debit or credit his account accordingly.

Of course, what is really happening here is that the broker is extending a form of credit to the trader, and the buyers of the “naked” shares (i.e., the counterparties to the initial short sale) are in turn trusting the brokerage. Because those 1,000 shares weren’t actually located and borrowed before the short sale, that transaction can’t be completed until the trader closes his position and buys back 1,000 shares (possibly from other individuals). At that point, any of the counterparties to the original short sale who maintained their purchase, can gain title to the shares out of the 1,000 the trader bought back when closing his position.

What if the trader has a heart attack before he closes the position? Or what if he made a terribly wrong guess, and the share price triples ten minutes after his initial short sale? This danger is why I earlier said that the trader relies on a form of credit from the brokerage; no matter how much he initially put up as collateral, the share price could rise such that he is on the hook for more money. Ultimately, the brokerage is responsible for delivering the proper number of shares to those who purchased them in the initial short sale.

Of course, it is possible that if disaster strikes, and a stock experiences a sharp jump while a trader holds a very large naked short position, then the brokerage could be unwilling or even financially incapable of rectifying the accounts of those who were counterparties to the initial short sale. In other words, they agreed with the trader to buy a certain number of shares at a certain price, they handed over their money, and then find out (after the shares have risen in price) that they don’t own these shares, after all.

Depending on the precise contractual understanding, this outcome would be either outright fraud, or at least a very embarrassing sign of incompetence. Either way, the brokerage would obviously seek to avoid such a predicament, and so (absent government regulations) would be very careful in facilitating short sales.

Well, if what these critics are saying is true, then it seems as if the major brokerages really are engaging in “outright fraud.” In other words, it’s not a mere matter of timing, where the sale goes through immediately rather than waiting 45 minutes for the broker to locate and borrow the shares. I am hearing all kinds of horror stories where people buy shares and then are strung along for months, when they ask for the actual certificates. Apparently the brokerage will simply say, “We can’t locate the certificates, we’ll let you break the trade if you want.”

So, if this is all true, then I should not have been so flippant in my article. The government is still to blame, naturally. These practices (I claim) would not last in a free market, where “regulation” is done through open competition and private sector analysts, rather than the monopoly SEC.

For those wanting to read more, check out the “Deep Capture Blog,” which was started by the CEO of Overstock. (He claims his company has been getting attacked by naked short sellers.) I hope to follow up on this, and write another Mises.org to correct for my (apparently) misinformed earlier article.

Comments are closed.