> There is a really simple reason for not allowing naked short selling and that is the potential for effectively creating a divide by 0 error, when the short sellers have to cover their short
The point of a naked short system is that short sellers never need to cover their positions.
Naked shorting allows any credit worthy institution to create synthetic shares as long as they continue to pay the dividends. That’s what makes it IMO a superior system. It eliminates the disruptive problem of short squeezes. Shorts can never get recalled, because they’re simply synthetic cash flow streams.
Overall we want more short selling in the market, and therefore want to remove as many constraints to short selling as possible. Short selling improves price efficiency[1], increases liquidity[2], reduces corporate fraud[3], and helps protect against speculative bubbles[4]
The whole point of capital markets is that companies can raise cash by creating shares, and then use that cash to make money for shareholders. Naked short selling subverts this by letting someone else issue shares of the company and use the cash their own way. Companies have to have a near monopoly on creating their own shares, or the whole system falls down.
If naked short selling is restricted to short term trades in special circumstances (as it is now), the system still functions and market makers have a little more freedom to create liquidity (whether the liquidity is worth the other issues is a question I won't try to answer here). Allow unrestricted naked shorting though, and the next time you buy shares in msft, it could turn out that your investment depends on msft dividends paid by a hedge fund betting on cattle futures more than it depends on microsoft's financial performance.
Naked short system is potentially very disruptive (like we are currently experiencing with GME), is essentially a tool for entities with large capital to synthetically induce bankruptcy earlier than necessary, and poses systemic risks. There is a reason there are regulations that attempt to guard against it.
Incorrect. Shorting cannot make a company go bankrupt, because it has no effect on the operations. Having a low stock price will not make a profitable company become unprofitable.
All short sellers can do is reveal pre-existing flaws In the company. Which is why the presence of short sellers reduces corporate fraud
Shorting can affect a companies ability to raise capital. All your comments sound like you live in a textbook, uncaring of what happens in the real world.
> Shorting can affect a companies ability to raise capital.
So can negative press coverage. And yes, either can prevent a company that is on the brink from staving off bankruptcy. It's questionable whether you ought to call the press coverage the cause of the problems, though, and the same objection applies to the shorting.
The point is that the value of AAPL is just the value of its future dividends. As long as a creditworthy institution guarantees the same stream of dividends, they are identical in value from the investors perspective.
The biggest asterisk is hand waving away the credit worthiness of the synthetic issuer. But this is a solved problem. We have plenty of derivative markets, where a counterparty guarantees some cash flow related to an underlying security. You just use central clearing houses and set reasonable margin. Nobody worries about whether their options will actually payoff or if their futures contract will default.
> As long as a creditworthy institution guarantees the same stream of dividends, they are identical in value from the investors perspective.
No, the stream of dividends doesn't have identical value.
There are other relevant corporate actions.
Shares can vote, your stream of dividends cannot vote.
If the company spins-off a segment it may distribute shares of the new company to shareholders while the owners of that third-party stream of dividends won't get anything.
If someone wants to acquire the company they will make an offer to buy outstanding shares, they won't care at all about those syntethic streams of dividends.
In general, if you want to sell a delta-one derivative that's fine. But you cannot sell that to someone who wants to buy a stock!
Would you want to be delivered a derivative when you bought a share in the market?
That wouldn't be shorting the stock, it would be selling something else. Related but far from identical.
Those are all great points, but IMO not really that difficult to handle.
> If the company spins-off a segment
A spinoff is just a divided in the form of stock in the new segment. This is easy to handle. The short is now simply short both one share of the original and one share of the spinoff. The long now owns synthetic shares in both.
> If someone wants to acquire the company
An acquisition is just a one-time terminal dividend to the company. In a cash acquisition the short owes the long the value paid for the stock. In a stock acquisition the short is now short the equivalent shares of the acquiring company.
> Shares can vote, your stream of dividends cannot vote.
This is the biggest wrinkle. But it basically still exists even in the current system. If a stock has short interest of 50%, then there's 150 shares held long for every 100 shares of float. In practice it's not really that big a deal because 99% of investors just vote the proxy.
At voting time, some investors will find they own synthetics and some will find they own originals. Just the same as today some will find their stocks on loan, and they can't vote. It doesn't really seem to make a difference.
IMO I think a requirement for public listing should be letting all beneficial owners, including those who own synthetic shares/have shares on loan. I think if anything it strengthens corporate governance, by avoiding voting rights shenanigans. The two classes have equal interest in setting the company perform well.
Sure, you can write a contract detailing all the possibilities. Maybe even get those derivatives listed.
But you could be doing that already!
I'm not sure what are you proposing that should replace "the current system".
Do you suggest that when you buy a share of J&J or whatever, and pay the price of a share of J&J, you may find later that what you got is a derivative product issued by "I can't believe it's not stock! Ltd"?
> Shares can vote, your stream of dividends cannot vote.
This is the biggest wrinkle. But it basically still exists even in the current system. If a stock has short interest of 50%, then there's 150 shares held long for every 100 shares of float.
In the "current system" there is no problem at all. Those who lent out their shares cannot vote.
Okay, for anyone who agrees with you on this the price of shares are predominantly decided by irrational investors.
And in a market where price of shares are predominantly decided by irrational investors, none of your purported benefits apply.
That's the point. Short selling acts as a tax on irrational investors. That's why short selling is linked to a reduction in speculative[1], corporate fraud[2], and price inefficiency[3]. It makes the market more rational, by driving irrational investors out of the market.
You know that widely acknowledged problem that a large part of current economic theory is completely divorced from the systems it is studying? This would be one of those parts.
AFAIK a stock that is available to lend does not have voting power. Hence, if you put a stock up for lending (even if no-one actually lends it) you can no longer vote with it.
This can be used to get more votes by borrowing stocks just to hold and vote.
IMO, the best system would be to let anyone who's a beneficial owner cast a vote with the rest of the share class. So, if the float's 1 million shares, and 500 thousand are shorted, then there's 2 million shares held long. Let them all vote. Make this system a requirement for listing on a public exchange.
Whether a long is synthetic/borrowed or primary, their interests are aligned. They both want the company to do as well as possible. It also avoids voting rights shenanigans that exist, even with the current borrow-to-short system. At the very least it seems extending voting rights to synthetic longs won't ipso facto make corporate governance worse. I see no obvious downsides. And the academic evidence shows that removing constraints to short sales makes corporate governance significantly better.
No that's false. Short selling a stock doesn't reduce the business's assets (except for treasury stock) or increase it's liabilities. Even if theoretically short sellers drove the $GME share price to zero the GameStop business would still exist.
The point of a naked short system is that short sellers never need to cover their positions.
Naked shorting allows any credit worthy institution to create synthetic shares as long as they continue to pay the dividends. That’s what makes it IMO a superior system. It eliminates the disruptive problem of short squeezes. Shorts can never get recalled, because they’re simply synthetic cash flow streams.
Overall we want more short selling in the market, and therefore want to remove as many constraints to short selling as possible. Short selling improves price efficiency[1], increases liquidity[2], reduces corporate fraud[3], and helps protect against speculative bubbles[4]
[1] https://academic.oup.com/rfs/article-abstract/24/3/821/15904... [2] https://img.iex.nl/iexprofs/images/2008-12-01ResearchEvidenc... [3] https://onlinelibrary.wiley.com/doi/abs/10.1111/jofi.12369 [4] https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261....