Thursday, 17 July 2008

(Eat my) Naked Shorts

Naked shorting is wrong. To see why, consider a company with 1,000,000 shares, trading at $10: it has a market cap of $10M. If a hedge fund sells shares it does not own and does not borrow - a naked short - it creates new shares. Suppose it shorts 250K shares. Then there are 1.25M shares out there - 1M real ones, and 250K created by the short - and so the stock price should fall to $8 to keep the market cap at $10M. Naked shorting destroys share prices without any real fundamentals, and so is illegal in many markets.

Note that how easy it is to put the short on depends partly on dividends. I'll let take over on that one:
To understand how a dividend cut can make short-selling easier, it's important to understand the mechanics of short-selling. Many stocks that short-sellers borrow are held by brokerage customers in margin accounts. When companies don't pay dividends, brokerage customers are encouraged to hold shares in those margin accounts.

The tax code creates this incentive system by treating dividend payments differently from substitute payments investors receive when their shares are lent to short sellers. When a customer's shares are lent out, the customer doesn't receive dividends. Instead, the customers receives a payment in-lieu of dividend, which lacks the tax advantages of actual dividends. Brokerage customers respond to this by holding high dividend paying stocks outside of margin accounts, making it more difficult for short-sellers to locate shares to borrow. The other side of the coin is that they move non-dividend paying stocks to margin accounts.
One might en passant suggest that people not sign up to margin accounts that allow their brokers to lend the stock, but that is another matter.

Now for what the SEC has done. It has not removed the problem of naked shorting in the US. Rather it has fixed it for 19 (and only 19) stocks. Dealbreaker again:
[The plan for these 19 financial stocks] requires short sellers to have not just located the stocks they want to borrow in order to short, but to actually borrow. From our read, 100% delivery of the stocks at settlement is required.
I have no problem with shorting at all, and there is some evidence that it makes the market more efficient. But naked shorting should be illegal not just for 19 US stocks, but for all of them. Get the borrow on first, then you can do the short.

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