Marketplace Scratch Pad

Getting Naked, Part 2

Scott Jagow Oct 1, 2009

This is a follow up on yesterday’s post about naked short selling. There may be some misunderstandings about what it actually is.

Clusterstock’s John Carney has a thoughtful slide show explaining why people are confused over naked short-selling and the idea of trading shares you don’t own. I highly recommend going through it. He says what people call naked shorting is really just shorting — essentially a bet against a public company. And true “naked” shorting is illegal and rare.

The key point about naked shorting is that no fake shares have been created, no forfeiting has occurred.

There are no phantom shares existing in accounts anywhere. And no additional selling pressure has been created that wouldn’t have been created by an ordinary short sale.

In fact, the naked short sale and the traditional short sale are economically equivalent. In either case you have one party who is the owner of the security and one party who is owed an obligation that the security be delivered to them and holds collateral for that obligation.

I’ll be interviewing John for this week’s After the Bell podcast, so tomorrow you can hear him explain his argument. In the meantime, he posted this in the comments section:

Offering to sell shares which you have no intention of acquiring is fraudulent and the practice is already banned.

My point is that naked short selling is not actually a major problem in our markets. In reality, manipulative, fraudulent naked shorting vanishingly small and not problematic.

John points out that all stock trades are “phantom” in that no one takes possession of actual shares. Buyers get a legal claim against a broker — a “securities entitlement.”

A lot of this boils down to the idea that people are trading something they don’t own — a concept that’s clearly gotten many, many people in trouble, not just on Wall Street but on Main Street. Why do we need to do this? John argues that clamping down on “naked” selling (the legal kind) will just make it that much harder to short a stock, and the market needs shorting.

As for the claim that short-sellers manipulate the price of stocks downward with rumors and company-bashing, that’s already illegal. You can argue there’s plenty of manipulation to the upside as well, and people rarely get busted for that, either.

Be sure to check out After the Bell tomorrow and feel free to add your thoughts here as we continue the discussion.

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