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If you have shares in an account, your broker can loan me your shares to sell and I have to deliver them back later after I buy them back after selling them. I am hoping to profit by buying them back at a lower price,

I will sell a stock when I believe it is overpriced. If I hold the shares, then I sell hopefully at a high and buy back when it is low.

But when I short, I do not have the shares to begin with so I have to borrow them and then sell what I borrowed. I must buy them back at some point and return them to the lender of the shares (normally the broker).

So a broker knows from all their accounts who has shares and they can agree to lend them to me even without informing the account holder who owns the shares. But if the shares are held as paper certificates by the owner of the shares and not electronically by the broker, then there is no way I can borrow the shares to sell unless the owner agrees to lend them.

So there are a few ways the broker cannot loan shares to short. One is when the shares are held by the owners as paper certificates. Another is the shares are held in an IRA account or other type of retirement account.

Who are the brokers? The major brokers are the Investment banks (Ibanks) such as Goldman sachs, JP Morgan, Lehman, Morgan Stanley, Others are online brokers such as Schwab, Ameritrade, etc.

What they do is lend shares to sell often without the account holder knowing the shares are being loaned out. They do this legally via fine print in the account agreement.

Shorting is legal and is known to help facilitate the flow of transactions by adding ‘liquidity’.

But ‘naked shorting’ is entirely illegal.

What has happened is this. The brokers like those that are listed above have learned they can allow their hedge funds to short shares without loaning them, without locating them in the first place. They think ‘Oh, the shares are out there somewhere in our account holders accounts, and we’d rather not bother to locate where they are, so we will just let our hedge funds sell the shares however they want and we will settle everything up later’.

So a brokerage hedge fund will be allowed to sell shares that may not exist at their parent brokerage. For example, say a Goldman Sachs (GS) hedge fund named GSHF sells 1,000,000 shares of Boeing (thinking it will lose a major contract) or it will sell 1,000,000 shares of Lehman. But if GS has only 500,000 shares of Boeing or Lehman among its account holders, then GSHF has just sold hundreds of thousands of shares that don’t exist in the GS brokerage bank.

Now the hedge fund, GSHF in our example, is required by SEC rules to deliver back the shares it shorted and bought back within 13 days. This is known as the REGSHO rule. But the SEC never enforces the 13-day rule. They, the SEC, are complicit in the naked shorting because it is so big a scandal that it would bring down Wall St. When the shares are not delivered back, they become known as a Failure-to-Deliver or FTDs.

So what the market is left with is a pile up of shares that are not real (FTDs). These are counterfeit shares and they never get settled by the Depository and Clearing Corporation (DTCC). And the DTCC refuses to release the data on unsettled short trades (FTDs) because they know there are enormous amounts of counterfeit sales from naked shorting and they know the data will sink the Ibanks on Wall St.

So this is the scandal of the last two decades when electronic stock trading took hold (and all other types of electronic trading). When it was a paper system, the counterfeiting of shares was minimal and would be prosecuted. Today with billions of trades performed electronically, the SEC has decided to look the other way even though they are aware it is happening.

This scandal dwarfs the Enron scandal.

Incidentally, this practice of naked shorting is linked with another practice of forcing margin calls and liquidations. But that is another post of which I wrote just a little about.

http://www.freerepublic.com/focus/news/2084284/posts?page=32#32

I have written too much already. Hope it has been helpful.

“But ‘naked shorting’ is entirely illegal.”

Actually, it is not illegal.

Notice that the SEC’s announcement says “abusive naked short selling”, not “naked short selling”. The SEC still allows investment firms to naked short but they must always cover the short. They can initiate a short sell through immediate borrowing without there having to be a stock borrowing transaction. In other words, if an investment firm thinks they can immediately capitalize on a short sell they can do so without actually borrowing the stock and selling it, but they must complete the transaction within T+3, or three days.

The SEC still refuses to required positive exchange of stock, a stock sell for cash, and a cash transaction for the purchase of stock. They will allow investment firms (you will never get this privilege) to make phony transactions as long as the initial stock borrowing is concluded within T+3. The SEC seems to believe that such a concluded transaction will not have a dramatic affect on creating depressed stock prices. I totally disagree.