Illegal Naked Shorting

In 2005, the SEC formally adopted Regulation SHO, establishing "locate" and "close-out" requirements to curtail naked short selling and other practices.

Naked shorting takes place when investors sell short shares that they do not possess and have not confirmed their ability to possess. It defines locate and closeout requirements relating to stock borrowed to execute short sales. It also limits trading in threshold securities that have experienced substantial Failures to Deliver in which stock in a short sale is not delivered at settlement. For an ordinary short sale, the stock must be located before the short sale can be executed.
However, “bona fide” market makers are exempted from this rule and can short shares without locating the stock. This is naked shorting which, if executed in accordance with the rules of Reg. SHO is legal. When these rules are not followed, it becomes an illegal naked short.

In 2010, Regulation SHO was amended via changes to Rule 201, which stops short selling on a security when prices have decreased by 10% or more during the trading day, mandating that new bids be above the current price.
If the stock involved in the naked short can be located and borrowed in the two-day period before settlement, it is just an ordinary short sale.

However, if the stock cannot be located and borrowed prior to settlement, it creates a Fail to Deliver (FTD) situation.

If the case of an FTD, a broker-dealer is supposed to take cash from the short account and purchase shares in the open market to close out the position.

“Bona fide” market makers who are perceived as providing liquidity to stock trading can maintain naked shorts for a longer six-day period.

In practice, these provisions are routinely circumvented so that FTDs are not closed out.

This results in the creation of counterfeit shares, which the DTCC treats in the same manner as legal, registered shares. A nearly unlimited supply of such counterfeit shares can be created to overwhelm buying an interest in a stock and drive down the price. This is a routine practice on Wall Street that is at the heart of innumerable manipulation schemes.

#nakedShortSelling #marketmakers #marketmanipulators