Naked Short Selling Would Live On

One day after the Securities and Exchange Commission ended its pilot project to clamp down on naked short selling, at least one academic says any decision to extend the plan to the broader market would have some unintended consequences.


Columbia Law School professor John Coffee says he believes that if the SEC chooses to extend the temporary naked short-selling rule to the entire market, it would have the effect of driving short sellers to migrate their investments to single stock futures, the options market and cash settled equity securities, all strategies that could also drive a company stock down. The last option, also known as total return swaps, don't involve real shares but are agreements between investors and bank derivatives dealers where one party pays the other based on the performance of the underlying stock price.

"I'm not saying it's a complete substitution but people who want to avoid preborrowing stock might be able to achieve these things through these other means," Coffee says.

The agency in July set up emergency restrictions on short sales in the shares of 19 financial institutions including mortgage giants Fannie Mae and Freddie Mac through Tuesday. The emergency restrictions required short sellers in these institutions to either arrange formally to borrow shares, "preborrow." Previously, it was enough if the broker could determine that it had a reasonable basis to deliver the securities when an investor sought to borrow shares for a short sale.

It's not clear what the SEC will do after it collects all the data from this effort, but Coffee adds that he believes those investors seeking to engage in naked short selling, the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed, will use these other mechanisms that fulfill the same functions. Coffee does add that even with short sellers finding these other means, he expects broad restrictions similar to those set forth in the emergency order to have some impact on discouraging the naked short- selling practice.

"It would succeed at putting some sand in the gears," Coffee said. - Ron Orol