Sep 18
Naked Short Selling - How Was This Ever Legal?
I just learned about something that is extremely disheartening and down-right scary. There has been a practice on Wall Street that I just learned about on This American Life called naked short selling. It was the final straw that broke the camel’s back for The Lehman Brothers Bankruptcy. They were engaging in naked short selling in the hopes of bringing their company out of dire straits.
Here is how it works. Let’s say that you are interested in purchasing 1000 shares of IBM. I tell you that I will sell you those 1000 shares IBM with the promise that I will deliver them in 30 days. Here’s the deal. I don’t actually have those shares. I have lied to you. But, here’s my plan. I sold you those shares on the hope that they would appreciate in value so I took your money, and bought the shares and now I am waiting for them to appreciate and the difference I take as profit. I plan to short sell your stock, and I am naked because I don’t actually own the stock I am selling…thus the naked short sell.
Now, if the price I sold you isn’t enough to purchase the shares I promised, I am screwed, and I default on the sale, but that is ok because all I have to do is avoid your calls for a while.
Bells should be going off in your head right now! Wait a second, you are selling me something that you don’t have, and in some cases, never intend to deliver. Isn’t this fraud? Isn’t this illegal? The answer to the fraud question is yes. But, hold onto your hats, the answer to the illegal question, at least until lately is no. WHAT?!?
Apparently, this practice stems from back from the day when there were no computers on the stock market, and traders send their assistants across the floor with wheelbarrows of paper stock in order to close a sale. Obviously this would cause a traffic jam and would bring the entire market to a stand-still, so the practice of a gentleman’s agreement that the stocks would indeed be delivered came to be accepted.
Flash forward to today were the entire Stock Market is driven by computers. Stocks are represented by 1’s and 0’s that flit about from one database to another at the stroke of a key. We no longer wait for a wheelbarrow of paper to close a stock trade. The stock now appears, as if by magic, in our accounts.
In this day of light-speed communications the arcane practice of naked short selling should have been eliminated a long time ago. We just don’t need that apparatus because of computers. Yet, it persisted.
Now, the Fed is closing this down, but that leads me to ask, what other BS is going on out there? People, it seems, will do anything if they make money and they won’t get caught. They will even believe that fraudulent activity is not only ok, but indeed a cornerstone in the proper functioning of the Stock Market. The Fed should have jumped in long ago to stop this practice. There may have been ramifications and short-term issues, but if our economy is depending on shaky, fraudulent practices, then its failure is sure. Once trust is lost, all is lost. Shame on you Fed for not stopping this earlier. This is ridiculous.
Photo Courtesy of www.exploreshop.com.
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Discussed this topic in class today, the teacher agreed. Its underhanded and very shady
Respectfully, let me play Devil’s Advocate with you.
You’ve got a couple of these principles down wrong. You don’t sell these imaginary shares (that you don’t actually own) in the hope that their value will go up; you sell them (you initiate your short order) on the hope that their value will go DOWN.
You say to a prospective buyer “I’m going to promise to hand these shares [that you don't have] over to you in a few months (or whatever span of time) for this certain promised amount. A few months later you HAVE to buy real shares to hand over as promised. The trick is that you are hoping their value DROPPED so your purchase price ends up cheaper than the originally agreed-upon sale price.
The other aspect that you haven’t mentioned is that you have to put up some original collateral against which you are making the purchase so instead of avoiding the buyer’s phone calls if things don’t turn out as you planned, there’s collateral against which the sales happens anyway, even if it’s at your loss.
In a way, this isn’t too different from buying shares on credit and selling them for a profit before the credit comes due. You are engaging on a bet with someone else: the other person is betting that the shares will go up whereas you will bet that the shares will go down. But there is some person on the other side of this deal. It’s not as “smoke and mirrors” as you describe it.
In a normal market this practice isn’t as destructive as you might think; it’s a way of saying “I think this stock value is inflated” and betting against the silly speculators (like the people who invested in the Dot-Com companies without doing their due-diligence) who “hype” a non-existent value and create artificial demand for a stock, thus “creating” value that doesn’t really exist.
In a collapsing market where consumer confidence is going through the floor, too much short selling can cause problems. Thus the TEMPORARY suspension of the practice.