Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale.
When the seller does not obtain the shares within the required time frame, the result is known as a "failure to deliver".
Such a trader first "borrows" shares of that stock from their owner (the lender), typically via a bank or a prime broker under the condition that he will return it on demand.
Failing to deliver shares is legal under certain circumstances, and naked short selling is not per se illegal. Byrne, have advocated for stricter regulations against naked short selling.
In 2005, "Regulation SHO" was enacted; requiring that broker-dealers have grounds to believe that shares will be available for a given stock transaction, and requiring that delivery take place within a limited time period.
Effective September 18, 2008, amid claims that aggressive short selling had played a role in the failure of financial giant Lehman Brothers, the SEC extended and expanded the rules to remove exceptions and to cover all companies, including market makers.
A 2014 study by researchers at the University at Buffalo, published in the Journal of Financial Economics, found no evidence that failure to deliver stock "caused price distortions or the failure of financial firms during the 2008 financial crisis" and that "greater FTDs lead to higher liquidity and pricing efficiency, and their impact is similar to our estimate of delivered short sales." Some commentators have contended that despite regulations, naked shorting is widespread and that the SEC regulations are poorly enforced.
Our agency’s rules are highly supportive of short selling, which can help quickly transmit price signals in response to negative information or prospects for a company.
Short selling helps prevent “irrational exuberance” and bubbles.
If the stock is in short supply, finding shares to borrow can be difficult.
The seller may also decide not to borrow the shares, in some cases because lenders are not available, or because the costs of lending are too high.
The trader's profit is the difference between the sale price and the purchase price of the shares.