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Naked Short Selling / Failing to Deliver
Naked short selling occurs when a seller sells a share of stock, and then fails to deliver it.
In a legitimate short sale, the seller first borrows a share of stock, and THEN sells it, hoping to buy it at a lower price before he returns it to the lender, his profit being the difference between the sale price, and his later buy price. It is a bet on a price decline, and legal as described. Sell high, buy low.
A naked short sale is a manipulative trading technique. It takes advantage of a structural deficiency in the system that allows a transaction to occur, and all moneys to be paid, before delivery occurs.
So a transaction goes by on the tape - a sale - and it is processed, and has an effect on the price of the stock, but the delivery portion of the transaction is left for days later. Meanwhile, the depressive effect of thousands of these sales extracts it toll on the price - the naked sales are still sales, and are treated as legitimate by the system.
At some point after the checks have been cashed and the commissions distributed and the fees paid, the share never shows up.
Illegal In Most Instances
Naked short selling is illegal as described - it can be legal in certain limited circumstances: for a market maker that needs to provide shares in a fast moving market for a thinly traded security, but in that instance it will buy the share back a few cents below where it sold it - Sell at $4.20, buy at $4,00 - which is part of legitimate market making. Or an options market maker will do so to hedge its sale of put options. These are legal, limited-time frame exceptions. All other instances are illegal.
The industry term for a naked short sale is a Fail to Deliver (FTD), because the seller fails to deliver.
The FTD is handled by the clearing and settlement system (the DTCC, a for-profit company wholly owned by Wall Street - the brokers) in two ways:
1) The stock borrow program at the NSCC (a subsidiary of the DTCC) enables that entity to borrow shares from an anonymous pool, and effect delivery to the buyer. The NSCC then creates a debit in the seller's account, and holds the cash from the sale (minus commissions, of course) as collateral. It charges a fee to do that, and the program was designed to accommodate "temporary" delivery failures - but has been abused over the years, as "temporary" has no fixed definition, and some unscrupulous hedge funds think "temporary" means years.
2) The non-CNS (Continuous Net Settlement) system, or ex-clearing (ex- meaning outside of) system, which allows the NSCC to handle the cash for the brokers and pay everyone, but leaves the delivery portion of the transaction outside of the system, between the two brokers, on the honor system. The brokers ALL have a ledger in their back offices where they keep track of the IOU's from each other, and this has resulted over time in a ghost, or phantom, float of electronic book entries in the system, with no stock existent to support the transactions - just IOU's.
The DTCC reports that the FTD problem amounts to $6 billion a day, marked to market. It is unclear whether that includes the ex-clearing transactions or not - the language used is ambiguous, and allows for different interpretations. Many have asked for clarification, and none has been offered - the DTCC doesn't like to talk about this, to anyone, including the regulators.
Critics of the DTCC charge that the Stock Borrow Program creates more book entries/FTD's/IOU's than there are shares of stock issued, which the DTCC has denied in carefully parsed language that actually doesn't deny the direct accusation. These critics maintain that the lending pool is replenished as shares are borrowed, delivered to the buyer's broker, then put right back into the pool by the new broker to be lent out again, thereby giving birth to IOU after IOU. The DTCC carefully argues that it never lends more shares than there are in customer accounts. This is technically true, as Lender A's account has no share in it once it is lent to Buyer B, but when Buyer B re-deposits the lent share into his DTCC account, available for loan, it then gets lent to Buyer C, leaving a nice little trail of IOU's as it worms its way through the system. The DTCC never addresses this, and instead answers questions that weren't asked, in the best tradition of politicians and bureaucrats everywhere.
The DTCC has said that only 20% of the transactions are handled via the Stock Borrow Program. That leaves the question of how the remaining 80% are handled. The answer is via the ex-clearing system.
How can the SEC allow this chronic failure to deliver to occur, creating a de facto phantom float of book entries/IOU's with no shares to support them? Aren't those in actuality counterfeit shares, falsely represented to the buyers as real? If they are treated by the system as equivalent to genuine shares for the purpose of creating a transaction, I would argue they are.
The system tells the buyer that all is well, and doesn't differentiate between a legitimately delivered share and an IOU. Thus, the buyer sees that he bought 1000 shares of ABC on his brokerage statement or on his screen - but there is no way of knowing how many are real shares and how many are IOU's without obtaining paper certificates, which cannot be counterfeited with the ease of an electronic book entry/tick/IOU. The brokers will tell you that of course there's shares there, or alternatively, that it is a non-issue, as the ticks can be sold at any time, getting the buyer's cash out of the trade. These explanations deliberately ignore that there is no attendant share to back up the IOU.
A share is a specific thing, a parcel of rights, from the issuing company. Among these rights are the right to vote, and the right to legal redress (you can sue them as an owner of the company), and the right to any dividends, cash or stock.
An electronic book entry without a share to back it up has none of these rights.
The lack of differentiation between real shares and IOU's has resulted in a market where we are trading claims on shares, rather than genuine shares, and oftentimes there are many more claims than there are shares. That is not the way the market is supposed to work.
Systemic Problem of Critical Scope - Rule 17A Sought to Prevent This