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Naked shorts “Yelling “fire” in a crowded theater is a terrible thing to do — unless there’s a fire.”
Thomas Dolan, Barron’s. He was writing about a wonderful financial market practice – sometimes legal, sometimes not – known as “naked short-selling”. His article explains what that means. I got interested after getting a DVD in the mail, called The Wall Street Conspiracy, that reckons that this practice was responsible for destroying many an honest business. Sounds a bit like Michael Moore, but I will give it a view to see if it stacks up or is a pile of crap. One quick thought: the idea of selling something you don’t own or haven’t even borrowed yet does sound awfully close to outright fraud, like insuring a house against fire if you don’t even own the house. Or like fractional reserve banking……….Aaarrgggghhh…
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I’m not sure how it could be illegal… sounds to me it is just a contract saying that you pay me X today, I will purchase and deliver the goods to you at time T and pocket the gain or eat the loss if the price at time of purchase is different from what you paid me. The only way I could see it being illegal is if you take the money and run or waffle out if you take a big loss when the day comes.
I agree with Dale. Naked short selling adds important liquidity to the markets.
What’s wrong with insuring a house you don’t own? I mean, I wouldn’t want to be the guy writing the policy, but if someone is willing, more power to em.
Alsadius
I wouldn’t want to be the guy living in the house!
Since Y’all are in my play pen:
Whenever one shorts a stock, or commodity, under current rules, one is selling what one does not own (you can’t short “against the box” anymore, tho’ once it was possible). So, if there is some kind of “short” that is not “naked” please write me at this address.
Thus, one has to borrow what one desires to sell— except!
“Naked” Calls: by which you sell someone the “option” to buy from you something you do not own.
Ah! but “Naked” Puts, where you pay someone for their commitment to buy from you something you do not own at the time of the commitment.
But, hedgers do that, and succeed, as per Jim Chanos.
Greenlight did me in on Allied Capital Mgmt. and rightly so.
Now Laird knows all this, and probably JP as well.
Insurance requires an “insurable interest” at the time of it’s inception, at least. — remember?
There is nothing whatsoever wrong with naked short selling. The seller signs a contract with the buyer which specifies that in some circumstances he might have to make delivery, and if the buyer chooses to take delivery, the seller must then obtain a share and hand it over. He does this by buying one from someone else, possibly at a loss. In practice, this seldom happens, and the two parties make up the difference in prices without worrying about it.
Given that, you might as well just structure the contract so that delivery is not required to take place. In fact, we have such instruments. They are called contracts for difference (CFDs).
Allowing short selling (naked, covered, equivalent instruments) is highly desirable. Markets in which it is easier to take long positions than short positions can lead to mispricing, as people who think that the market is overvalued find more obstacles to making money if they are right than those who think it is undervalued. Therefore, markets in which short selling is difficult are more prone to bubbles than markets in which it is easy. (Classically, housing markets have this problem). Many of the financial problems that have occurred over the last few years would have been moderated if bears had been able to take short positions more easily.
The sorts of businesses that go bust due to the presence of short selling are businesses that are based on the continuation of unsustainable bubbles. Short selling can make these bubbles burst sooner and these businesses go bust quicker. Good.
Short sellers are good guys.
From a technical standpoint, short positions are necessary for certain risk management strategies. Specifically, there are regions of the efficient frontier that are inaccessible if shorts are disallowed, which means optimum asset allocation in certain types of portfolio management strategy is impossible.
Naked short selling is responsible for a $1 trillion annual drag on the economy as hedge funds use it to destroy the value of good companies, and since many companies finance their employee pension funds with company stock, which creates an incentive to the employee to work hard to make the company successful, naked short selling is responsible for destroying the pension savings of millions of people. Hedgers and corporate raiders also do this to take over companies on the cheap.
David Gillies, there’s a difference between covered short selling, which is a valid practice, and naked short selling.
Stupid question time. If you are short selling a stock, who are you borrowing the stock from? Why would they let you borrow their stock for the purposes of selling it? And when do they get the stock back?
Not a stupid question at all…Shorting is not intuitive so don’t feel bad about asking… shorting anything means you are agreeing to provide the stock/commodity/whatever at an agreed future date but at the price it is today when you take the short position… and the way you provide it is to buy it (i.e. cover the position) ‘at market’ on or before the due day of the short… so you are hoping that the price will go down and therefore be less than you paid for it.
Brokers lend stock held in custody for their customers to short sellers and are paid a premium by the short sellers. If the owner of the stock wants his certificate he can demand it and it must be delivered.
In the old days there were often short squeezes when those who were long demanded delivery and God help the shorts in the scramble to buy in what they had sold if there wasn’t enough stock out there. Naked selling makes it possible for there to be more shares owned than are outstanding.
” He who sells what isn’t his’n must buy it back or go to prison”
Our regulators, and the SEC in particular, are incompetent and as useful as tits on a bull. They were warned of Madoff repeatedly, but were too stupid to do anything. Maybe they couldn’t tear themselves away from the porn on their computer monitors. The current administration has such an unerring eye for hiring dreck,that one wonders if it is deliberate sabotage.
This is what anyone having worked for the Gov’t would expect.
Where the “risk” comes in that the SEC attempts to address is the acceptance of a sell order executed before shares have been “borrowed,” and the seller does not have a long position at that broker.
I have enountered this issue with some ETFs, which can often require a “premium” as well if they are in short supply.
So, the effort is to stop selling of shares that are neither owned nor borrowed at execution of order. But, the one “naked” is the broker, not the seller.
That’s why hedgers use the biggies for those moves.
Renminbi –
A slight correction, short selling makes it possible for more shares to be traded and subject to claims than are outstanding, but there can never be more owned than issued and outstanding.
And then there are “Due Bills.”
I’m struggling with the idea that short selling is immoral and should be illegal. Huge swathes of business activity would dry up overnight. How many factories get built on spec, just in case a manufacturer happens along and chooses to buy the finished product ? You sign a contract promising to deliver a factory, or an oil rig, or an aeroplane, and then you go and build it. Tsunamis, strikes, financial difficulties, government action may intervene preventing you from delivering. You may then get sued. But this mode of business is hardly immoral or illegal. Why should securities be any different ?
One benefit, by the way, of the shorts is in damping the real world consequences of excessive bullishness. If there’s a housing boom in a world where shorts are allowed, mad bulls can either buy real houses, construct new ones, or buy paper houses off the shorts. If and when the shorts prove to be right, they win their bets with the mad bulls who bought their paper houses. But to satisfy these particular mad bulls enthusiasm to buy real estate, no extra houses had to get expensively built, and now lie unoccupied. Instead of a real waste of capital on real houses, all we’ve had is a transfer of cash from bulls to bears.
Naked short selling creates temporary counterfit shares. The financial system treats these counterfit shares as if they’re legitimate for the first few days. A few days is an eternity on a digitally traded exchange, so several (dozens, hundreds?) legitimate transactions involving the shares may have taken place before a problem comes to light. If the original transaction “fails to deliver”, the current financial system gives counterfitters the option of naked short selling a fresh round of fakes. Naked short selling dilutes the value of stocks and destroys the chain of ownership, even for legitimate shares. Our markets will face catastrophic instability until securities are digitally protected from this kind of fraud by cryptography at the single share level.
Lee Moore is entirely correct.
I used to run a small business, mainly engaged in writing software code for company’s websites. Everything contract we ever signed entailed selling something that not only didn’t we own, it didn’t even exist yet. We only created the software once we got the contract. No sale, no creation.
If you ban advance sales, you’re banning a large proportion of business activity. Madness.
Naked short selling is responsible for a $1 trillion annual drag on the economy as hedge funds use it to destroy the value of good companies,
Bullshit. If it lowers share prices, that is because companies were overvalued. If the companies get into trouble as a consequence, that is because they were bad companies, not good ones. Bad companies deserve to be punished for being bad companies, so that capital can be better allocated elsewhere. (And yes, I am talking about the benefits of making it easy to take short positions *in general* rather than talking about the naked/covered distinction, which is a technical issue that I don’t actually think matters much. It may actually be better to discourage this and instead encourage people to take short positions via derivatives markets, which they can easily do).
The truth is that we have had massive capital misallocation in recent decades. Capital has been far too cheap, and much investment has gone to all kinds of stupid places where it cannot generate a genuine economic return. Many companies have believed that they were good companies when in fact all they were doing was milking the fact that they had an unrealistically cheap cost of capital. For the last five years or so, this state of affairs has been ending, which is horribly painful. It would be over quickly if more people (politician, homeowners, and stakeholders in companies doing useless thing) would actually get it into their stupid heads that it has to end.
and since many companies finance their employee pension funds with company stock, which creates an incentive to the employee to work hard to make the company successful, naked short selling is responsible for destroying the pension savings of millions of people.
If there is anything more stupid than having your pension money in the stock of the company that you work for, I am hard pressed to know what it is.
The reason it does not happen in conventional insurance is that insurers are aware of such issues like arson. If I buy fire insurance on a house I don’t own, it is only likely that an insurer would be happy for that to happen is if I could show that I had a clear interest in protecting the house, IMHO. The potential for abuse in certain economic conditions is obvious. It magnifies moral hazard.
In recent years, the credit derivatives market has developed to the extent that people were able to buy default insurance contracts (credit default swaps) on loans and bonds that they had no direct exposure to. This created the potential conflict of interest issue in which a buyer of a default swap had an incentive, in some conditions, to push a firm towards bankruptcy in the hope of getting a payout. You had instances of traders shorting the stock of a firm so as to push it over the edge in the hope of getting an insurance payment. This might seem extreme but apparently, it did come close to happening.
I think my attitude towards buying of CDS contracts and other insurance where you don’t have any clear ownership of the insured asset is that it should not be illegal, but financial institutions can have no-one but themselves to blame if these things go wrong and cause trouble. And in today’s more straightened circumstances, I would hope that financial intermediaries are far less able and willing to write such policies in the first place.
and since many companies finance their employee pension funds with company stock, which creates an incentive to the employee to work hard to make the company successful, naked short selling is responsible for destroying the pension savings of millions of people.
If there is anything more stupid than having your pension money in the stock of the company that you work for, I am hard pressed to know what it is.
This. Company pensions should – must – be fully funded, and managed by a third party. Otherwise, unscrupulous managers will loot the pension fund and fill it with IOUs. Having the pension fund invest in company stock is one of the ways the managers can artificially prop up the share price – to make themselves look good – while the company is actually going down the toilet.
bradley 13 – interesting point.