Wednesday, April 29, 2009

The SEC and naked short-selling

The SEC's currently accepting comments on various rules intended to curb naked short-selling. I know a number of people who have a knee-jerk reaction, going "Why should the SEC tell someone they can't make a particular type of deal?". Well, it has to do with the nature of the deal. In a legitimate short sale, the seller has arranged to be able to cover the position and deliver the stocks. They may have an options contract to buy those shares before the delivery date, or they may be borrowing actual shares from someone. In the latter case if the stock price goes down far enough the seller can buy cheap shares on the market, deliver those to the buyer and never touch the borrowed shares. If the stock price doesn't go down the seller delivers the borrowed shares to the buyer and pays off the lender according to his agreement with them. In all cases actual shares exist to cover the position.

Naked short-selling doesn't work that way. When shorting naked, the seller sells shares that don't exist, that he doesn't have. If the stock price goes down far enough, he buys cheap and delivers to the buyer. If the stock price doesn't go down, he shrugs and walks away from the deal. He never delivers the shares to the buyer, and the buyer's broker unwinds the transaction leaving the buyer with his money back and no shares. If you think this is harmless, think about this: you've sold a put option to someone and made a purchase of shares to cover that option because the price is good and you'll make a profit. The guy you bought the shares from was naked-shorting the stock, and since the market price isn't below what he sold for he walks away from the deal. You don't lose your purchase price, but you also don't have the shares you need to have to cover your option contract. Now you're faced with two bad choices: buy at the now-higher market price and see your profit on the options contract turn into a loss, or default on that contract yourself. Your wallet or your reputation, one or the other takes a major hit. Still think the naked short sale was harmless? I don't. Just because you got your money back doesn't mean you avoided all the costs of a failed purchase.

IMO naked short-selling should be banned entirely. If you want to short, you should be required to make arrangements to guarantee delivery at the time you initiate the sale. You can purchase the shares, you can purchase an options contract, you can borrow from a willing lender, but one way or another you have to have something in hand to guarantee delivery before you can sell. Along with that I'd put in a rule saying that if you default on any sale your broker is then required for 1 year to refuse to initiate any sale for you unless you own actual shares to cover it. No borrowing, no options contracts, if you fail to deliver you're on shares-on-the-barrelhead until you prove you're reliable again. Now the whole problem's eliminated.

I'm sure certain traders who like to gamble won't like that, but I fail to see why they should be allowed to gamble in ways that leave other people unwittingly holding the bag.

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