Naked short selling is the practice of selling a financial security short without first borrowing the asset or confirming that it can be borrowed.
Mechanics and market regulations
Standard short selling requires a trader to borrow an asset and sell it on the open market, with the expectation of buying it back later at a lower price. Naked short selling bypasses the borrowing step entirely. The trader initiates a short position but does not possess the underlying asset to deliver to the buyer. If the trader fails to acquire the shares by the mandatory settlement date, the transaction results in a failure to deliver.
The practice is illegal or highly restricted in most major international financial markets. The United States Securities and Exchange Commission banned the practice for equities following the 2008 financial crisis. The European Union implemented direct bans on the naked short selling of shares and sovereign debt in 2012. Regulatory bodies in jurisdictions like Japan and Australia enforce strict financial penalties for market participants who execute short sales without a located borrow. There are limited exemptions for designated market makers who use temporary naked short positions to maintain market liquidity.
High volumes of naked short selling artificially inflate the supply of a security. This excess supply drives down the price of the target asset. It distorts the actual circulating share count of a company. For Elephants researching market mechanics, tracking failure to deliver rates provides insight into potential naked shorting activity in a specific stock.
Example
Imagine an agricultural supply company named Savannah Elephants Ltd is trading on a public exchange. A trader believes the stock price of Savannah Elephants will decline over the next week. Instead of paying a broker to locate and borrow 1,000 shares, the trader enters a sell order for 1,000 shares directly into the market. A buyer on the other side of the trade purchases those shares. When the settlement date arrives, the trader cannot produce the shares because they never borrowed them. The trader sold phantom stock, artificially increasing the supply of Savannah Elephants shares without any real assets changing hands.