The news that almost 33 million shares Lehman Brothers were sold and not delivered to buyers on time in the days before its bankruptcy is sure to revive the old theories that short-sellers somehow manipulated the price of the stock through the practice of “naked shorting.” It shouldn’t. Naked shorting—selling a stock without first borrowing it—has almost no effect on the price of a stock.
This will strike many people as a shocking statement. To many investors, naked shorting seems fraudulent. Indeed, securities regulations treat much naked shorting as a type of fraud. The most vigorous critics of naked shorting sometimes liken it to counterfeiting. But this view seems to be based on a misunderstanding of the mechanics and effects of naked shorting.
The critical view ignores the fact that all short-selling creates a somewhat “artificial” level of selling pressure. Short selling creates sales that are not generated by current holders of stocks who want to sell. Outsiders–short sellers–who do not own the stock are selling it. This has costs for holders of the stock–the stock prices may go down–but benefits for the broader market, especially would-be buyers who get more rational pricing on securities. Crucially, however, nothing really turns on whether this additional selling happens through a traditional short sale or naked shorting.
An academic paper from Christopher Culp and JB Heaton explains the economic equivalence of short-selling and naked shorting:
Recall that with a traditional short sale there is (1) a party owed shares (the former security owner that lent shares to the short seller) that retains the purchase price of the shares as collateral; (2) a party that owes shares (the short seller) who will receive proceeds on delivery of the shares; and (3) a new owner of the shares.
A naked short leads to an almost identical situation. There is (1) a party owed shares, now the NSCC and ultimately the undelivered-to buyer who retains the purchase price of the shares as collateral; (2) a party that owes shares (the short seller) who will receive proceeds on delivery of the shares; and (3) an owner of the shares, now simply the former would-be security owner.
There is nothing economically important about the ultimate identities of the parties who hold otherwise-equivalent economic receivables and obligations. Despite the contentious rhetoric that sustains public debate over naked shorting, there are no especially meaningful economic differences between the two.
If you are really interested in this stuff, we recommend you read the entire paper, which we’ve posted below for your benefit.
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