Nothing Naked About Short Sales

The Securities and Exchange Commission jumped on Congress and the Bush administration bandwagon in trying to shield Americans from any alleged negativity that results from the practice of capitalism. In the SEC's case, it will tighten short selling rules for 19 financial stocks lately battered by negative investor sentiment.

Seemingly forgotten by Nanny Washington is the basic truth that capitalism without risk is not capitalism. If nothing is risky, then the truly risky assets will not reflect market-clearing value and as such, will go wanting when it comes to interested investors.

Investors speculate whether they're long or short on company shares. When they expect a company to prosper, they go long on those shares and existing shareholders benefit through greater demand for that which they own. The economy benefits as well from market-driven speculation pushing capital to what markets deem its highest use.

On the flipside, short selling is a very risky form of speculation. Short sellers borrow shares to sell in the present under the supposition that when they cover their sale later with a share purchase, there will be a profit for the shares having falling in the interim. While a long purchaser only risks the funds invested, a short seller could see the shares sold go skyward — think of those who sold AOL short in the fall of 1996 before six splits of those same shares.

The economy is a great beneficiary of short selling in that this allows for negative sentiment about any company to be priced into the value of the company. If short sellers are vindicated by a falling stock price, capital is more quickly deployed to better uses and the broad economy benefits.

When this form of speculation is restricted, as in when regulators seek to muddle the process of price discovery, there exists an unseen negative for companies not achieving the best possible ownership. For one, takeovers that usher in new owners with new ideas about how to maximize the value of a company's assets might never occur due to the buyer being unwilling to pull the trigger on a firm whose value has not reached market-clearing levels.

Secondly, anyone with even the most rudimentary knowledge of money management knows that investors large and small have "wish lists" when it comes to stocks. There are many companies that investors are eager to own, but not at existing price levels. If short sellers achieve what some deem a short-term aim, a company can benefit over the long term for the shares falling into the hands of interested, long-term owners.

Naked shorting involves selling shares that the sell-side broker does not immediately have possession of. But for most shares, this is handled with ease. Once a client expresses interest in shorting the shares of a certain company, the broker checks with the trading desk to understand the "borrow" on those shares as a way of assessing if those shares can be sold short.

For shares that are "easy to borrow," the "naked" nature of a sale is irrelevant, and also legal, given the ease with which the executing short-sale broker will be able to deliver the shares to the buyer.

If shares are deemed "hard to borrow," brokers have to do additional legwork to be sure that the stock is available to be shorted. If the shorted shares are not delivered to the buyer within the three-day settlement period, this is called a "fail to deliver," as in the short-seller did not actually possess the shares sold. But this is somewhat corrective too in that if the shares are not located within 13 days, the broker who executed the trade must buy them back; thus nullifying the initial sale.

It should be said of "naked" shorting that long buyers are frequently naked themselves. Indeed, they often purchase shares through a broker without the correct amount of cash to cover the purchase. Importantly, this process is self-regulating in that those who fail to transfer the cash to complete the trade on the settlement date can have their accounts closed for trades being broken. Ultimately the shares sold short must be delivered, and the short seller faces major risk if the speculation proves incorrect. If brokers develop a reputation for failing to deliver the shares sold short, they find it difficult to locate those willing to transact.

It can't be stressed enough that contrary to visions of speculators flooding the markets with non-existent shares, there are two sides to every trade. Without a buyer who has a different opinion than that of the seller about the company in question, there is no short sale to speak of. In short, one cannot hedge anything without the existence of a contrarian speculator. It should also be said that those speculators who think the short-sellers are wrong are not buying shares they expect will not be delivered.

Without the SEC, the market for short sales would prove self-regulating very quickly. Furthermore, the liquid nature of the 19 financial stocks covered under the SEC's plan are not the kind of shares that are hard to borrow.

SEC Chairman Christopher Cox will doubtless pat himself on the back for aiding certain companies during a difficult period for the markets, but the losers will be many, including investors, the companies protected, and the economy itself.

Investors will lose for having to put capital to work in a market distorted by regulatory machinations, the protected companies will lose for their shares not reaching natural market levels that would put their shares in the right hands, and the economy will lose for capital not working efficiently in sorting out the market's winners and losers.