Naked shortselling is a controversial and potentially illegal practice that allows institutional players like market makers to manipulate the stock market at will. In this article, we’ll take a look at what naked shortselling is, how it works, and how it can have serious consequences for the economy. We’ll also discuss how the direct registration of stocks can help prevent this practice from occurring.
1. What is Naked Shortselling, and How Does it Work?
When a stock is sold short without first borrowing the shares or verifying that they may be borrowed, this is known as “naked shortselling.” This is illegal under certain circumstances, such as when it is done with the intention of artificially driving down the price of a stock. an investor sells short a stock, they are betting that the stock will drop in price. If the stock does indeed go down, the investor can then buy it back at the lower price and profit from the difference. However, in order for this strategy to work, the investor must actually borrow the shares from someone else before selling them.
With naked shortselling, the investor doesn’t bother to borrow the shares first. Instead, they simply sell the shares and hope that the price will go down. If the price does go down, they can then buy the shares back and profit from the difference. If the price goes up instead, the investor is in trouble, because they don’t actually own the shares they’ve sold.
2. How Can Naked Shortselling Be Used to Manipulate the Stock Market?
Naked shortselling can be used to manipulate the stock market in several ways. For example, a group of investors could coordinate a naked shortselling campaign against a particular stock, with the goal of driving down its price. This could cause the stock’s price to plummet, even if there is no real reason for it to do so.
One potential consequence of naked shortselling is dilution of shares. This happens when an investor sells more shares than actually exist, effectively creating “phantom” shares. This can dilute the value of the existing shares, which can be damaging to the company and its shareholders.
Additionally, dilution of shares can also make it more difficult for a company to raise capital in the future. If investors perceive that a company’s shares are being diluted, they may be less likely to invest in the company. This can hinder the company’s growth and success, and ultimately lead to job losses and other economic problems.
3. How Can Direct Registration Help Prevent Naked Shortselling?
The Depository Trust and Clearing Corporation (DTCC) is a major player in the world of naked shortselling. The DTCC is a central clearinghouse that holds stock certificates on behalf of investors, brokers, and other market participants.
One way that the DTCC can facilitate shortselling is by allowing brokers to create loans against the stock certificates that are held in their custody. As long as the DTCC has the stock certificates in their possession, brokers can loan them out to shortsellers who use them to sell short and drive down the price of the stock.
Unfortunately, this practice has been abused by some brokers who have been caught loaning out shares behind their customers’ backs. This means that investors who thought they owned a particular stock might actually find out that their shares have been loaned out and are being used to bet against their own investment.
One way to help prevent naked shortselling as well as unpermitted Rehypothecation is through the use of direct registration of stocks. With direct registration, investors’ stocks are registered in their name directly with the company’s transfer agent rather than through a brokerage firm. This makes it more difficult for investors to engage in naked shortselling, because they must actually own the shares they are selling.
4. How Can Naked Shortselling Harm the Economy?
Naked shortselling can have serious consequences for the economy. It can be used to manipulate the stock market and create bubbles that ultimately burst. This can cause a lot of volatility in the stock market, which can make it difficult for investors to make informed decisions.
Additionally, naked shortselling can harm the companies whose stocks are being sold short. If a company’s stock price is artificially driven down, it can make it difficult for the company to raise capital, which can hinder its growth and success. This can ultimately lead to job losses and other economic problems.
5. The Potential for a Massive Short Squeeze
One potential consequence of naked shortselling is a massive short squeeze. This could happen if a large number of retail investors become aware of the practice and decide to direct register (DRS) their stocks in response. A current example of this is the ongoing GameStop short squeeze resulting from a large number of retail investors individually registering their shares in their own names with GameStop’s transfer agent, Computershare.
In this scenario, the naked shortsellers would be forced to buy back the stocks they have sold short, but they might not have the necessary shares to do so. This could cause the stock’s price to skyrocket, resulting in huge losses for the naked shortsellers.
Additionally, the sudden influx of new DRS shares could create a sudden and massive increase in demand for the stock, potentially causing a bubble in the market. If not managed properly, this could ultimately lead to a crash.
The potential for a massive short squeeze is one of the biggest risks of naked shortselling and excessive failure to deliver. By taking steps to prevent these practices, we can help protect the economy and promote a more stable and fair stock market.
Overall, naked shortselling is a dangerous practice that can harm the economy. By using direct registration of stocks, investors can help prevent this practice and promote a more stable and fair stock market.
To learn more about naked shortselling, check out Susanne Trimbath’s book Naked, Short and Greedy.