The SEC issued an emergency order this week on naked shorting . It aims to abolish the practice in the 19 named financial institutions by further narrowing the existing rules of Reg SHO for a limited period.

The order requires short sale shares be available in broker inventory or through a consummated arrangement to borrow the shares, and that the shares settle on the 3rd day. Reg SHO currently requires only that the shares be identified in the market for borrowing.

The order is intended to eliminate naked shorting’s false downside effect on share prices of the named financial institutions. Let’s have a look at what the practice does and why it artificially emphasizes selling pressure. I’ll leave the parsing of the agency & industry politics re: the rule to others.

In order to sell shares of xyz corp. short, a current shareholder has to agree to lend you their shares to sell (a broker acting on the other shareholder’s behalf is the customary method). Otherwise, you don’t have anything to sell. Then, at a later date, you buy xyz corp. shares in the open market and return them to the source that lent them to you.

A naked short is selling shares of xyz corp. without having borrowed the shares before you sold short. The shares are eventually acquired but not by the point that you are selling them short ,and at times, not within the three day settlement period. The practice creates downside pressure on share price without having any shares accounted for in the public float to sell, no matter if it’s 72 hours or 4 hours after the short sale that the shares are acquired.

The result is that there is selling of more shares of xyz corp. than there are actually in circulation. This causes excess downside pressure on share price, creating a false valuation (i.e. lower price than there are shares to support). When coordinated among a few short sellers, substantial price erosion can be made to occur, which creates more selling by genuine shareholders. This can make shares available for the short seller (or their broker) to backfill the borrowing requirement for the original short sale, or at least cover it until shares are borrowable.

As can be seen, it’s a shell game. By selling shares you don’t have yet (naked short), you cause selling in the stock by genuine shareholders. This creates short sale profit without valid sales and new share inventory gets created, which can be used to support your borrowing but well after you sold short. Banning the practice completely is just common sense if you’re intending to have fair and stable markets.

Shorting as part of a comprehensive fundamental or technical valuation analysis is a routine function of free market trade. Naked shorting is a rogue practice designed to exacerbate fear and distorts fair value of share price by leveraging more selling capacity than is present in an enterprise’s public float.