Today I will differentiate between naked short-selling and regular short-selling.
In a legal stock short, you are selling something you don't own in your portfolio. The broker is required by regulation to hold stock in the amount of your short. If the broker has another holder of the stock internally, they can match the two up. If not, they are supposed to go to another broker and borrow the stock. This borrowing regulation is meant to keep the total amount of shorts equal to or smaller than the amount of the stock issued and trading. If the broker cannot find the stock to borrow for a certain number of days, they are supposed to close out your short sale by buying like securities in the market. Until the security is borrowed, the position is a naked short-sell. This incidental type of naked short-selling is not illegal.
Naked short selling becomes illegal when there is no intention to borrow the stock to cover the short on the part of the buyer or the broker. This type of trade would be made to manipulate the price of the security. Let me give an example of how that occurs.
Remember a naked short sell occurs when the borrowing of the stock has not occurred. This artificially creates an increase in supply of the stock. You have all the stock issued plus the amount you sold short. When you increase the supply of something and the demand remains constant economics tells us the price will fall to the point where supply and demand are again in equilibrium.
So an illegal naked short seller will sell the stock with no intention of borrowing to cover the short. They will fail to deliver the stock to the Depository Trust Corporation which clears securities transactions or to another broker if it is traded outside the DTC. They will repeat this transaction again and again to increase the supply and drive down the price. This manipulation of the market is clearly illegal.
Tomorrow I will write about others who might participate in the illegal activity.
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