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The economics of naked short selling: naked shorting is little different from permissible shorting.

Article Excerpt
Securities and Exchange Commission regulations define a "short sale" to "mean any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller." That is, a short seller sells shares he does not own; instead, he delivers to the buyer shares that are borrowed from a shareholder. Later, the seller must "cover" the loan--he must buy shares and deliver them to the lender. Short sellers operate when they believe the price of a security will fall--in essence, they sell borrowed shares today at a high price and then pay back the lender with lower-priced shares in the future.

Many financial economists believe that some short selling is necessary to prevent prices from reflecting only the views of the most optimistic investors in the market. In doing this, short sellers moderate prices both when they are shorting and when they later cover. Nonetheless, short selling has long been unpopular with security owners because they believe it can depress stock prices. There is little if anything security owners can do to prevent permissible short selling.

A broker/dealer can accept a short sale order from a customer or effect a short sale for its own account so long as it meets the following conditions:

* It has borrowed the security or made a good faith arrangement to borrow the security, or

* It reasonably believes it can locate and borrow the security by the settlement day, and

* It has documented compliance with either of the above two requirements.

Some forms of short selling are illegal. When a seller sells stock short but has not borrowed the security or made a good faith arrangement to borrow the security, or does not reasonably believe it can borrow the security by the settlement day, the short seller is probably engaged in impermissible "naked" short selling.

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Naked short selling has been the focus of an increasing number of lawsuits. One plaintiffs' lawyer prosecuting these suits argues that the practice is "the largest commercial fraud in U.S. history, involving hundreds of billions of dollars." Outside the legal community, those decrying the practice range from fervently opinionated individual investors to the U.S. Chamber of Commerce, which asked the SEC in January 2007 to take additional steps to stop naked short selling. Regulators and exchanges have shown a willingness to crack down on alleged violations of prohibitions on naked short selling.

Despite the cries of alarm, we believe that naked short selling is unlikely to have significant detrimental effects on capital markets. In this article, we will first examine the relevant economics and regulation, and then argue that, from an economic perspective, naked shorting is little different from traditional shorting.

THE ECONOMICS OF SHORT SELLING

The conventional wisdom is that short selling drives down the price of the stock being sold. The SEC often receives excited opposition to the practice of short selling, much of which invokes accusations of conspiracy theory and nearly religious fervor against short selling in general and naked short selling in particular. At the same time, financial economists long have been skeptical of the value of regulations that constrain speculative short selling because of a conviction that short sale constraints may allow overpriced securities to remain overpriced.

THE GOOD SIDE Prices are socially valuable signals. Short selling can correct irrational overpricing if and when it occurs and, for that reason, financial economists usually object to regulatory constraints on short selling.

In Figure 1, the shares outstanding before any short selling are fixed at quantity [Q.sup.o]. The curve labeled [D.sup.o] is an "excessively optimistic" demand curve. Before any short sales, the price that clears the market at the existing supply of shares is [p.sup.o]. A short sale can be viewed as a short-term increase in the supply of the stock--say, from [Q.sup.o] to [Q.sup.o+s]. The market-clearing price at this "as-if" quantity is [p.sup.o+s], which is lower than [p.sup.o].

In this example, short selling depresses prices. But that alone cannot make short selling profitable and, therefore, does not provide an incentive for speculative short selling. In particular, the price decrease is only temporary if demand does not fall at given prices, because it will disappear when the short seller covers the short. If the demand curve remains fixed at [D.sup.o], then the short's effect on prices...

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