I’m gonna share some personal information with you. We’re all friends here, so I’m trusting you not to use this against me.

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I only have one kidney. I found out about it somewhat recently. I didn’t know it until my 40s, but apparently, I got shorted one.

It’s not ideal. 

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It also means that, should I ever offer to sell you two kidneys, I’ll have to borrow at least one. If I borrow that kidney with the secret intention of buying both kidneys back at a reduced price, this is called a short sale. 

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If I propose to sell you two kidneys, but nobody has agreed to lend me a second one, this is called a naked short sale. The second kidney does not exist. 

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Not only is this proposal dishonest, but it could have a damaging impact on the kidney market writ large. For one thing, our transaction has artificially inflated my personal supply of kidneys, thus distorted the apparent supply and demand of kidneys on the marketplace. This distortion could undermine our very ability to place an accurate price on the value of a human kidney.

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And that’s why it’s illegal…naked short selling, that is. Human organ trafficking is also illegal but, like, for so many reasons that have nothing to do with market structure.

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But I digress.

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On this week’s episode of Let’s Talk Market’s co-hosts Dave Lauer and Pink kick off their far-ranging conversation with a look at the practice of naked shorting internationally, and also talk about abusive short selling in more developed markets. The long and short? Market abuse and manipulation are real - both long and short - and they’re hurting everyday investors. 

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Defining our Terms

Before we get to that conversation, let’s define our terms…y’know, just in case you learn better without analogies about human organ trafficking. 

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What is Short Selling?

Short selling occurs when an investor, believing a stock to be overvalued and anticipating a drop in market price, borrows or arranges to borrow a number of shares from a broker, sells these borrowed shares on the market, buys them back at a reduced price, returns the borrowed shares to the broker, then pockets the difference.

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It’s a strategy with the potential to yield serious profits.

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It’s also extremely high risk (see GameStop;-). Whatever else it is, short selling is also totally legal. 

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What is Naked Short Selling?

Well, for one thing, by contrast to the form of short-selling above, it’s illegal, generally speaking. However, market makers have an exemption that many call the Madoff Exemption, that allows them to sell shares they don’t have located. The rub? They ultimately need to deliver those shares.  

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Illegal naked shorting is market manipulation. It’s everything that short selling is, as described above, without an arrangement to borrow in place. Naked short selling is the practice of selling shares that you not only don’t have, but that you can’t prove exist, and that may, in fact, not exist.

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As the SEC defines it, naked short selling occurs when the seller neither borrows, nor arranges to borrow, the securities required to make delivery within the standard two-day settlement period. In other words, the naked short sell isn’t the mere intent to make a sale without actually having the shares. It’s the actual failure to deliver those shares to the buyer.

The SEC calls this a “failure to deliver” or more succinctly, a “fail.”

South Korea Shorts Shorts

The good news is that there’s tons of enforcement action going on around abusive short selling. The bad news? It’s not really happening here. South Korea on the other hand—

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Earlier this week, South Korea’s Financial Services Committee placed two major investment banks under investigation for naked short selling. As in the U.S., the practice is illegal in South Korea. FSC Vice Chairman Kim So-young revealed that other major investment banks have also engaged in the illegal practice and that further investigation will likely reveal more targets.

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Kim asserted that “Neglecting rampant illegal short selling makes it difficult to form fair prices in the stock market, and this is highly likely to hurt individual investors and decrease trust in the nation’s market, which has a high proportion of individual investors.”

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To show that they mean business, the FSC has placed an outright ban on all short selling practices of any kind until June of 2024. South Korean regulators argue that abusive shorting practices are so widespread that this is the only way to begin untangling the knot.

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But That’s Just There, Right?

Well, Dave Lauer would take issue with that conclusion. In light of South Korea’s recent actions, Dave tweeted, “South Korea continues its crackdown on naked shorting. The idea that abusive short selling and market manipulation isn't happening in other markets is absurd.”

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We’re guessing that, by “other markets”, he means the U.S.

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Impossible, you say? We already have laws against that sort of thing, don’t we? 

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That’s true. We have something called Regulation SHO. Enacted in 2005, Reg SHO began with the intention of updating the rules around short sale practices. While we’ve had regulations on the books for overseeing short sales since as far back as 1938, regulators saw a growing trend toward failures to deliver. 

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But even at the time, Reg SHO wasn’t actually meant to eliminate the practice of “naked shorting.” As the SEC noted at the time, “‘Naked’ short selling is not necessarily a violation of the federal securities laws or the Commission’s rules. Indeed, in certain circumstances, ‘naked’ short selling contributes to market liquidity.” (They’re mainly talking about the aforementioned Madoff exemption here)

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To an extent, it was defined as a practice that could satisfy a sudden surge in consumer interest while addressing a temporary shortage of shares. But the idea was that the seller had to actually know that the shortage was temporary. 

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Presumably, the sale of not-yet-acquired shares would be made in good faith with the knowledge that the real shares would be available soon.

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But what if those sales were not made in good faith?

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Reg SHO was an effort to address these practices before something terrible happened.

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And then something terrible happened.

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At the front edge of the financial crisis, investment banks Lehman Brothers and Bear Stearns collapsed spectacularly. And in the heap of debris left behind, forensics experts found considerable evidence that institutional investors engaged aggressively in naked short selling, flooding the market with phantom shares, driving down prices, and smothering two firms hanging on life support in a mountain of pillows. 

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If you weren’t around for the Great Recession that followed, we can tell you that it wasn’t awesome. 

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And it prompted further refinement of Reg SHO. In 2010, the SEC amended Reg SHO, adding a number of rules designed to reign in abusive short selling. 

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Among them, Rule 203(b) requires “a broker-dealer to have reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due before effecting a short sale order in any equity security. This “locate” must be made and documented prior to effecting the short sale.”

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Naked Short Selling, Yeah.

According to the rules, If I promise to sell you two kidneys, I have to document my success at locating a second one before I can ink the deal. But who’s gonna lend me a kidney in this market? If only there were some kind of loophole…or dozens of loopholes.

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We’ll stop short of elaborating on each of these loopholes here, mostly because the specific mechanisms used are less important than the core fact—abusive practices remain rampant. 

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As Dave Lauer explains in this week’s podcast, it doesn’t matter what you call them. You can call it naked shorting, abusive shorting, or The Build-a-Share Workshop. By any name, it amounts to market manipulation, and it hinders price discovery in ways that hurt everyday investors, undermine businesses, and ripple through our markets.

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Dave offers a retort to those who view Reg SHO as evidence that we’ve addressed the issue. Words are one thing. Actions are another altogether. Regulatory agencies like the SEC and CFTC simply lack the budget, technology, and personnel to confront these abuses in all their complexity and counter-regulatory maneuvering. 

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So while it may be fun to say naked shorting, this isn’t about one issue, or one form of abusive trading. 

Instead, Dave concludes, “There are serious problems all over markets—we see that in enforcement actions in the Metals Markets, the Treasury Markets, in Equities Markets—there are all these crazy market manipulation scandals, price fixing scandals—in the U.S., in Europe, in Canada, and elsewhere. So I think It’s good to be honest about these problems, and whether regulators have the resources to fight these problems. And it’s good to be clear eyed about serious issues with abusive short selling.”

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Regulation is always just the tip of the iceberg. Actual enforcement remains a challenge far wide and deeper.