I wrote a comment in response to Jarda Brychta’s Morning Commentary from August 19th, where a question was raised about the (il)legality of naked short selling, as the answer provided was not entirely accurate. Since it’s already written, I thought it would be beneficial to share it with everyone.
Short selling is legal as long as the rules for delivering the underlying asset are followed. Specifically, the underlying asset should be borrowed before the short sale to ensure it can be delivered within the time frame stipulated by the rules.
If this does not happen, it results in a situation known as FTD (Fail To Deliver), which is a problem.
If a trader does not secure the underlying asset for short selling, it causes a naked short selling and a violation of the rules. Naked short selling should not occur if regulation and oversight are functioning properly. This oversight is conducted by the SEC, but even the SEC has been under pressure, for example, in the GME case, which should lead to tighter rules and increased scrutiny.
FTD (Fail To Deliver) occurs when the underlying asset is not delivered within the stipulated time frame. This can happen for various reasons, ranging from administrative errors and technical issues to intentional manipulation, chained trades, offshore transactions, etc. Additionally, it can occur because borrowed and shorted shares can be immediately re-lent by the new buyer, leading to the effective re-lending of the same shares. As a result, it is theoretically possible to short more shares than the actual float.
Market makers also have exemptions to ensure liquidity and execute trades, allowing them to engage in short selling with the intention of acquiring the shares for delivery later, which might theoretically or deliberately fail.
So, naked short selling is regulated, it should not occur, and it is essentially prohibited. However, as I briefly described here, it is effectively allowed to occur in the U.S. due to a set of rules and regulations.
Therefore, it cannot be directly stated that naked short selling is illegal, even though it is generally labeled as such. However, in cases of intentional naked short selling, it is clearly illegal, though it can be quite difficult to prove.
Without any illusions, I believe that naked short selling is used daily in large volumes. If there is no limit on the number of shares that can be shorted, it’s clear that this method is very attractive for generating high profits.
For example, take a look at Gaming Wall St on HBO, where you’ll find a statement from a trader who intentionally engaged in naked short selling every day without any oversight.
There are several initiatives aimed at supporting a stricter ban on intentional rule violations, but so far, they seem to be in vain. After all, the Wall Street lobby is likely stronger…
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