Naked Short Selling Explained

Naked short selling is the practice of selling shares without first borrowing them or ensuring they can be borrowed. Unlike a conventional short sale—where the seller borrows shares, sells them, and later buys them back to return—naked shorting skips the borrowing step. That creates the risk of “fails to deliver” and can distort supply, price discovery, and market confidence.

Key takeaways

• Naked short selling involves selling shares that have not been located for borrowing or borrowed—often illegal or restricted.
• It can increase volatility, create artificial supply, and enable price manipulation.
• Regulators have enacted rules (e.g., Regulation SHO in the U.S.) and reporting requirements to curb naked shorting, but loopholes and operational failures can allow it to persist.
• High‑profile market events (e.g., Lehman Brothers in 2008, the GameStop episode in 2021) have spotlighted the practice and driven regulatory changes.

How it works

1. A trader sells shares they do not own and have not borrowed (or located for borrowing).
2. The trader hopes the stock falls so they can buy shares later at a lower price to cover the short.
3. If the seller cannot obtain the shares when settlement is due, the trade results in a fail to deliver (FTD).

Naked shorting can create false liquidity—apparent shares that don’t actually exist—distorting the market’s supply-and-demand signals.

Market implications

• Price pressure: Excess shorted positions can push a stock’s price down regardless of fundamentals.
• Settlement risk: Fails to deliver can disrupt clearing and create counterparty risk.
• Unfair trading environment: Retail investors and issuers may be disadvantaged if share counts are effectively inflated.
• Potential for manipulation: Coordinated or excessive naked shorting can be used to drive down prices illicitly.

Legal and regulatory response

Regulations vary by jurisdiction, but most major regulators treat naked short selling as illegal or tightly restricted.

United States
* Regulation SHO (2005) requires broker‑dealers to locate shares before short selling and created rules to reduce persistent fails to deliver.
* Additional transparency measures in the early 2020s require reporting of securities lending and short activity to improve oversight.
* Emergency and rule changes after the 2007–2008 crisis further tightened prohibitions on abusive naked shorting.

International approaches
* European Union: ESMA requires disclosure of significant net short positions and can impose temporary bans.
* United Kingdom: The FCA enforces disclosure and can ban short selling of individual stocks.
* Japan: Has rules similar to an uptick requirement for short trades.
* Hong Kong and Australia: Allow only covered short selling (shares available to borrow) and require reporting or impose restrictions during stressed markets.

Historical context and notable examples

• Early history: Short selling dates back centuries and has periodically provoked bans and regulation.
• 2007–2008 financial crisis: Spikes in fails to deliver in institutions like Lehman Brothers raised concerns that naked shorting exacerbated market stress.
• 2021 GameStop incident: Extremely high short interest (reports suggested short interest exceeding available shares) and a retail-driven short squeeze highlighted how excessive short positions—covered or uncovered—can trigger extreme volatility and settlement problems.

Rules and safeguards commonly used

• Locate and borrow requirement: Brokers must have a reasonable belief that shares can be borrowed before effecting a short sale.
• Close‑out requirements: Regulators may force firms to close out persistent fails to deliver.
• Uptick or alternative uptick rules: Restrict short selling when a stock is rapidly falling to prevent downward spirals.
• Reporting and transparency: Disclosure of short positions and securities lending activity to detect abuses.

Related concepts (brief)

• Short covering: Buying back borrowed shares to close a short position.
• Short squeeze: A rapid price rise that forces short sellers to cover, often amplifying the price move.
• Securities lending: The legitimate practice of loaning shares to enable covered short selling, typically with collateral and fees.
• Covered call writing: Selling call options while holding the underlying security to generate income.
• Synthetic short forward: Using derivatives (options, etc.) to replicate a short position without borrowing or selling the underlying.

Conclusion

Naked short selling bypasses normal borrowing safeguards and can undermine fair, orderly markets. Because of its potential to create artificial supply, cause fails to deliver, and facilitate price manipulation, regulators worldwide restrict or prohibit the practice and have implemented rules to increase transparency and enforce close‑outs. Investors and market participants should understand these rules and the risks associated with short selling, particularly naked shorting, which remains widely viewed as abusive and dangerous to market integrity.