The Naked Truth: A History of Naked Short Selling and its Controversial Legacy in Finance

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     There's a well-known adage in the financial world: "Buy low, sell high." It's a straightforward and time-tested way to make a profit, but what if there was a way to do the exact opposite? That's where naked short selling comes in. It's a practice that has been controversial since its inception, with some claiming it's an essential tool for market liquidity, while others argue it's a form of financial fraud that undermines the integrity of the financial system.

    So, what is naked short selling? Why is it so controversial? And how did it come to be in the first place? In this article, we'll explore the history of naked short selling, tracing its roots from the early days of the stock market to the present day.

The Early Days of Short Selling:

    Short selling is a practice where investors borrow shares of a stock from a broker, sell those shares on the open market, and then buy them back at a lower price to return them to the broker. The difference between the sale price and the purchase price is the investor's profit.

    Short selling has been around for centuries, dating back to the Dutch East India Company in the 17th century. The first short selling ban was instituted in Amsterdam in 1610, but short selling continued to be a popular practice despite its legal challenges. In the United States, short selling was legal but faced similar challenges. During the Panic of 1792, short selling was banned in the United States, but it was eventually lifted, and the practice continued to be used by investors.

The Emergence of Naked Short Selling:

    Naked short selling is a variation on short selling, but instead of borrowing shares of a stock to sell on the open market, the investor sells shares they do not possess. In other words, they "create" shares out of thin air and sell them. This practice is controversial because it can lead to a situation where there are more shares of a stock in circulation than there are shares actually issued by the company. This is known as a "phantom share" or "fail to deliver."

    Naked short selling emerged in the late 1990s and early 2000s when the internet and electronic trading platforms made it easier to execute trades quickly. Some argue that naked short selling is a necessary tool for market liquidity, as it allows investors to take positions in stocks without having to find shares to borrow. However, others argue that it's a form of financial fraud that allows manipulators to drive down the price of a stock and profit from the resulting panic.

Regulatory Response:

    Naked short selling has been the subject of much regulatory scrutiny over the years. In 2004, the Securities and Exchange Commission (SEC) issued Regulation SHO, which aimed to address the problem of "fails to deliver" in the market. The regulation required brokers to "locate" shares to borrow before executing a short sale, with a deadline for delivery of three days. If the shares were not delivered within that time frame, the broker would be in violation of the regulation.

    However, Regulation SHO did not address naked short selling directly. It was not until 2008 that the SEC issued an emergency order banning naked short selling in the stocks of 19 financial institutions, including Fannie Mae and Freddie Mac. The order was lifted in 2009, but the SEC continued to take action against naked short selling, including bringing enforcement actions against firms that engaged in the practice.

Controversy and Debate:

    The controversy around naked short selling only intensified in the aftermath of the 2008 financial crisis. Critics of the practice pointed to instances where naked short selling had been used to manipulate stock prices, exacerbating market volatility and contributing to the crisis. Proponents argued that the practice had been unfairly blamed for the financial collapse.

    One of the most high-profile cases involving naked short selling occurred in 2006 when Patrick Byrne, the CEO of Overstock.com, began a crusade against what he saw as a coordinated effort by short sellers to manipulate his company's stock price. Byrne claimed that naked short selling was responsible for driving down the price of Overstock.com's shares, and he launched a public campaign against the practice, even going so far as to file a lawsuit against several Wall Street firms.

    Byrne's crusade against naked short selling attracted widespread attention, and he became something of a hero to those who believed that the practice was a threat to market integrity. However, his claims about the extent of naked short selling and its impact on his company's stock price were met with skepticism by many in the financial community. Some accused Byrne of being a conspiracy theorist and suggested that his campaign against naked short selling was nothing more than a distraction from the problems facing his company.

    While Patrick Byrne's critics were vocal, subsequent events have proven him to be at least partially right, if not completely vindicated. For instance, in 2008, the SEC introduced new regulations to combat naked short selling, and in 2016, a group of banks, brokers, and hedge funds settled a class-action lawsuit that accused them of engaging in a conspiracy to naked short sell shares of Overstock.com. In recent years, there has been increased attention on the issue of short selling, and some commentators have argued that Byrne was ahead of his time in identifying the potential problems associated with the practice.

The Legacy of Naked Short Selling:

    Today, naked short selling remains a controversial and polarizing topic in the financial world. Some argue that it's a necessary tool for maintaining market liquidity and allowing investors to take positions in stocks without having to find shares to borrow. Others argue that it's a form of financial fraud that undermines the integrity of the financial system and can be used to manipulate stock prices.

    The debate over naked short selling is unlikely to be resolved anytime soon. The practice continues to be the subject of regulatory scrutiny and enforcement actions, but it's also a deeply ingrained part of the financial system. As long as there are investors looking to profit from fluctuations in stock prices, there will be a demand for short selling, both naked and traditional.

Conclusion:

    The dangers of artificially inflating a stock's float through naked short selling cannot be ignored. When investors sell shares they do not possess, they create the illusion of an increased supply of shares, which can drive down prices and cause panic among investors. This can have serious consequences for the broader financial system, as we saw during the 2008 financial crisis when naked short selling was accused of exacerbating market volatility and contributing to the collapse of several financial institutions.

    As such, it is essential that regulators take action against those who engage in fraudulent practices such as naked short selling. By cracking down on market manipulation and ensuring that the financial system becomes transparent and fair, regulators can help to restore confidence in the markets and protect investors from unscrupulous actors looking to make a quick profit at their expense. Ultimately, only by ensuring that the markets are functioning properly can we build a financial system that is stable, sustainable, and equitable for all.