A quick primer on what naked short selling is. First of all, short selling, which is a completely legal and often beneficial activity, is when an investor bets that the value of a stock will decline. You do this by first borrowing and then selling the stock at its current price, then returning the stock to your original lender after the price has gone down. You then earn a profit on the difference between the original price and the new, lower price.
What matters here is the technical issue of how you borrow the stock. Typically, if youre a hedge fund and you want to short a company, you go to some big-shot investment bank like Goldman or Morgan Stanley and place the order. They then go out into the world, find the shares of the stock you want to short, borrow them for you, then physically settle the trade later.
But sometimes its not easy to find those shares to borrow. Sometimes the shares are controlled by investors who might have no interest in lending them out. Sometimes theres such scarcity of borrowable shares that banks/brokers like Goldman have to pay a fee just to borrow the stock.
These hard-to-borrow stocks, stocks that cost money to borrow, are called negative rebate stocks.
In some cases, these negative rebate stocks cost so much just to borrow that a short-seller would need to see a real price drop of 35 percent in the stock just to break even. So how do you short a stock when you cant find shares to borrow? Well, one solution is, you dont even bother to borrow them. And then, when the trade is done, you dont bother to deliver them.
You just do the trade anyway without physically locating the stock.
Thus in this document we have another former Merrill Pro president, Thomas Tranfaglia, saying in a 2005 email: We are NOT borrowing negatives
I have made that clear from the beginning. Why would we want to borrow them? We want to fail them.
Trafaglia, in other words, didnt want to bother paying the high cost of borrowing negative rebate stocks. Instead, he preferred to just sell stock he didnt actually possess. That is what is meant by, We want to fail them. Trafaglia was talking about creating fails or failed trades, which is what happens when you dont actually locate and borrow the stock within the time the law allows for trades to be settled.
If this sounds complicated, just focus on this: naked short selling, in essence, is selling stock you do not have. If you dont have to actually locate and borrow stock before you short it, youre creating an artificial supply of stock shares.
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