So what exactly does this emergency order that Chris Cox announced this afternoon? A lot of people are scratching their heads about the rule because most naked-short selling is already prohibited under the rules. Maybe Cox just thought the markets didn't have enough uncertainty in them right now.
It's still unclear but here's what we're hearing. First of all, whatever it is it seems that it is broader than Fannie and Freddie. It applies to all primary broker-dealers also. Basically, if Ben Bernanke has recently granted you access to the discount window, it's going to be much harder to short you.
Second, it's going to be more than merely stepped up enforcement. We hear from sources who claim their familiar with the thinking (if you want to call it that) at the SEC that there will be new rules in place. What are the new rules? The rules put in place a few years ago allow primary broker-dealers and specialists to place and accept short selling orders from one another without requiring that they borrow shares first. This can be done for liquidity and market-making purposes but critics of naked short selling often say it can be easily abused.
Additionally, it's been a consistent claim by those who think abusive naked shorting is rampant that short-sellers intentionally misrepresent to broker-dealers that they have legitimately borrowed the stock or that they actually own the shares.
The bottom line is that we're hearing from sources in Washington that Cox may be looking to curtail one or possibly two of these loopholes. One move may be to require investors to certify in writing that they have located and borrowed the stock. Alternatively, the SEC could require short sellers to borrow, sell and close out their short trades through the same broker, eliminating the portability of short trades. They may also eliminate the broker-dealer exception. It's not expected that the specialist loophole would be eliminated, since this is still looked at as an important part of the smooth functioning of the market.
What's short selling? After the jump, we explain it in six sentences. (And then explain "naked shorting" in just five.)
Traders who believe a stock's price will decline borrow stock through a broker. They immediately sell the borrowed stock. Later, when it comes time to return the stock, they buy it on the market. If the price of the shares has declined since the original borrowing, they profit from the difference. It can be a risky bet, because if the shares go up after they are borrowed and sold off, the short-seller stands to lose money. Since there is no limit to how high a share can climb, short-selling creates a potentially unlimited upside risk. Want more: here's an in-depth guide to short-selling.
Naked short sellers skip the part where they borrow stocks. They sell shares they don't own, and only need to locate shares later when the buyer expects delivery. Sometimes they don't deliver the shares at all, which produces what the market calls a "failure to deliver." Is that illegal? Well the SEC rules make it very difficult. But you probably won't got to jail unless you the SEC can show you are attempting to manipulate the market or commit fraud.