Naked short

Adapted from an enlightening Reuters blog:

These have been significantly affected by the EU Short Selling Regulations introduced in 2012.

Uncovered or “naked” shorts

“Naked” shorts are positions whereby a firm sells shares that they do not own or have not borrowed. Instead of buying or borrowing the shares before selling them on, the seller will hope to purchase the shares prior to delivering on its sale or in some cases will just fail to deliver those shares.

Example

Seller X sells shares in A at $50 each for delivery on T+3. X hopes that the value of A’s shares fall in the interim period so that X can purchase A shares at less than $50 before delivering them to the buyer whilst pocketing the difference.

Naked short selling can lead to “failed to deliver” notices whereby the short seller is unable to obtain the securities and therefore fails to deliver them to the buyer. Such fail to delivers were suspected of having created market volatility and sharp decreases in share values.

Short Selling Regulations

The new regulations largely do away with naked short selling by requiring firms to have either borrowed or be able to borrow shares to cover their short positions (or in the case of sovereign borrowing to have some corresponding hedge).

In respect of company shares the regulations require either that a firm has:

•Borrowed sufficient shares to settle the short trade; •Entered into a binding agreement to borrow those shares; or •Has an arrangement with a third party (known as a "Locate") under which the third party has confirmed that the shares have been located and there is a reasonable expectation that they will be delivered.