The Securities and Exchange Commission (SEC) issued new rules to govern the use of naked short selling. Naked short selling is the act of selling financial instruments without first acquiring or borrowing the security within the date of settlement. With every purchase of a stock there is a sale of a stock; when this parity does not exist, there is a failure of delivery. Much attention has been on the malfeasance of speculative traders, but in reality delivery failures occur without intention, often the result of delay in locating shares on a timely basis, due to the ubiquitous purchase and sale by many investors, the speed of technology, and the slower speed of the physical transfer of securities. There has been much blame that naked short selling was a major contributor to the current financial collapse of many leading financial corporations. While many applaud the efforts by the SEC, there is anecdotal evidence both for and against the use of naked short selling.
Critics of short selling say that short selling has been used by various market speculators that have the intention of driving down the price of market shares. One has to question what type of speculator could make an impact. Does this speculation happen by accident or is it made by a concerted effort, either by many small investors acting in concert, or by a few investors with the financial power to effect major markets. It is highly unlikely that there could be a large number of small investors acting in concert. However, the SEC’s new rules do not require large investment money managers, such as the now prevalent Hedge Fund Managers, to disclose their short sale activity to the SEC. Hedge fund managers are so common that many people fail to realize that the major difference between a hedge fund manager and a common mutual fund manager is that a hedge fund manager may engage in more speculative investing and are not as limited as a regulated investment company.
Proponents of short selling do not deny that naked short selling is based on speculation. Their argument is that speculation provides a benefit to the market by providing liquidity and making trading more efficient. They also claim no one would engage in the short sale of institutions that were financially sound; and these companies were sold short because they were weak and the market acted as it should, and punished it. The Securities Exchange Act of 1934 required the settlement of stocks to be delivered within three business days. In 2005 the SEC enacted an amendment to the SEC act of 1934, establishing a threshold for shares that failed to deliver. Any stock where more than 0.50%% of a company’s outstanding shares, that failed to deliver for five consecutive days, were in violation of the SEC Act. While a company might be in violation of the SEC Act, it does not mean that the company did anything wrong. The SEC enacts rules and regulations, but because of a shortage of funds and employees they are often powerless in enforcing those regulations and determining if there was anything wrong, which intimately leads to more abuses.
There have been many questions regarding naked short selling and how it affects the market. Many of these questions have not been answered; because the SEC lacks the authority to obtain the answers. Naked short selling in the wrong hands can be dangerous, if government and regulatory agencies have no authority over those who are responsible for breaking laws, then the costs will be absorbed by everyone else.