What is naked short selling?

By Annalyn Censky, staff reporter


NEW YORK (CNNMoney.com) -- "Naked short selling" is the buzz on Wall Street, since a German ban on it sent the stock market tumbling Tuesday. But no, it's not something kinky.

The term "short sale" refers to a type of bet investors can make in the financial markets when they believe a stock or bond will fall. It becomes "naked" when the seller makes the bet without having the goods to back it up.

"Essentially, you're selling something you don't own," explains David Musto, a professor of finance at the University of Pennsylvania's Wharton School. It sounds impossible, he said, but here's how it works:

When a traditional short seller thinks, say, a bond is in trouble he will set out to borrow the bond, sell it to a buyer at its current market value, and then buy it back after its price falls. He can then pocket the difference and return the security to the bond's original holder, who he borrowed it from in the first place.

But in a "naked" short sale, the short seller makes the deal without ever having access to the securities to begin with. Perhaps he doesn't know anyone he can borrow it from, Musto said. Or he originally had access to a lender, but then some event in the marketplace altered his ability to borrow and deliver the goods.

Until the short-seller has bonds to deliver, the buyer doesn't have to pay. But by showing that a sale has taken place even though the goods haven't actually been transferred, a naked short-sale artificially drives a stock's price down to a level that's not reflective of true supply and demand, said Sharyn O'Halloran, professor of political economy at Columbia University.

Germany banned these so-called naked shorts on government debt and large financial firms late Tuesday, as a way to stabilize what has been a very rocky bond market for Europe, as countries in the region try to finance their debt.

The ruling prohibits investors there from short-selling without proof that they access to the underlying bonds to back it up. By doing so, essentially the ban limits short sales to investors who have access to large brokers or big reserves, O'Halloran said.

The whole purpose is to make their financial markets more transparent and for prices to better reflect true supply and demand, she said.

Throughout history, regulators have cracked down on short selling after a period of economic declines. In the U.S., at the the height of the financial crisis in September 2008, the Securities and Exchange Commission temporarily banned investors from short-selling 799 financial companies.

Yet in spite of its stigma, short selling serves a purpose, Musto said.

"It's a standard part of how markets operate. It's how they bring negative information to bear in the markets," Musto said. "When someone starts trying to restrict it, it seems like an act of desperation." To top of page

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Index Last Change % Change
Dow 17,778.15 421.28 2.43%
Nasdaq 4,748.40 104.09 2.24%
S&P 500 2,061.23 48.34 2.40%
Treasuries 2.20 0.06 2.61%
Data as of 11:26pm ET
Company Price Change % Change
Bank of America Corp... 17.53 0.27 1.56%
Apple Inc 112.65 3.24 2.96%
Oracle Corp 45.35 4.19 10.18%
General Electric Co 25.14 0.71 2.91%
Microsoft Corp 47.52 1.78 3.89%
Data as of 4:03pm ET

Sections

Russia's economic turmoil has already spread to companies in the West and many brands are bracing for a bigger blow to earnings. More

The shale boom has been a blessing to Texas, but tumbling oil prices are casting a shadow over the state. More

Portland's mayor says the city will create new rules, eventually allowing Uber to operate there. More

With two recent IPOs and a digitally-inclined audience of entrepreneurs, non-traditional financing could finally get its big break. More

Payday lenders are spending millions of dollars in Washington in an attempt to get powerful politicians on their side as a government crackdown on the industry heats up. More

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.