Tuesday, June 16, 2009

In defence of naked short selling – or why the crackdown on a phoney problem is costing taxpayers at least a billion dollars

Brief synopsis: a misguided government policy driven by fraudsters in the stock market is making the market less efficient at a cost to taxpayers of at least a billion dollars.

This post has two start points – a start point for people unfamiliar with the basic operation of short selling and risk arbitrage – and a start point for most my readership (who seem to be hedge fund managers).

Start point for readers without a financial market background

There are readers that do not know what short selling is – and what naked short selling (allegedly) is. So to help readers out – imagine I think for some reason a particular stock will go down – and I want to bet that it goes down. Then there is a mechanism by which I can make that bet. I can “borrow” the shares (say some shares in Citigroup). Then I sell those shares in the market (selling what I do not own – and have only borrowed). If the shares go down I can buy identical shares back in the market and return the identical shares. Rather than aim to “buy low and sell high” I just reverse the order – I aim to “sell high and buy low”. As an ordinary shareholder I can stuff up by “buying low and selling lower”. As a short seller I can stuff up by “selling high and buying (back) higher”.

When I buy back the shares (either at a profit or loss) I close out the transaction by returning them to the person I have borrowed them from. At all times my account is collateralised so the risk to my broker is minimal. [The risk to me unfortunately is not.]

Naked short selling is a much promoted – but in my view almost entirely fictional problem – whereby people do the short selling but without actually borrowing a share first. When they do so they will inevitably fail to deliver the shares to the exchange on the due date. The existence of fails is – at least according to the proponents of the “naked short selling hypothesis” proof that there is a major problem. But fails have happened since time immemorial (including in highly liquid markets such as Treasuries). There is usually a requirement to post cash collateral if you fail to deliver the actual security – and historically a small fine from the exchange (increasing over time).

Still some people have argued that a collateralised fail-to-deliver in a financial market has the ability through price manipulation of a stock to bring a business to its knees. Sorry – but generally the business does not care who owns the stock or what is going on the stock market unless the business is weak and needs capital. [This is the corollary of the old Wall Street truism: “the stock doesn’t know you own it”.]

Most short selling is mere speculation – but sometimes it involves arbitrage. Arbitrage is kind of useful and goes on all the time in financial markets. For instance if Company A agrees to buy Company B for stock the price should converge – over time – on the agreed stock swap deal. But if for some reason it does not arbitragers could buy company B’s stock and shortsell company A. When the Company B stock converts into company A shares they could just deliver the new Company A shares in satisfaction of their short-sale agreement. This allows the holders of company B to sell their shares at full price whilst the details of the takeover are sorted out. Arbitrage is the process which makes financial markets more efficient – it makes it so there is one price which means markets treat people more fairly. Arbitrage is by-and-large a good thing. Perfect arbitrages rarely (if ever) have substantial profit for the arbitrageurs. Indeed at best you are picking up pennies. Efficient markets reduce the profits of market participants at least on a per-transaction basis. That is usually a good thing if the public doesn’t want to subsidize sophisticated money market types.

Start Point for people with decent financial market knowledge

“Naked short selling issue” was a phoney issue – promoted by flim flams, stock promoters and other market slime-bags invented a problem which did not exist but helped them to promote their stock or justify the failure of their own businesses. The idea was that “miscreant” short sellers sold stock that they did not own in order to drive down the stock price and drive the company out of business. Bloomberg (and others) have taken the idea seriously. Gary Weiss has done a great job on his blog of exposing the slime-bag proponents of the imaginary naked short selling problem for what they are (which is usually crooks).

The story was that selling stock you did not own was producing “counterfeit shares”. I have yet to see mischievous naked short selling of any real business – though I have seen some fails-to-deliver (that is not actually being able to borrow the stock on the delivery date) remedied a few days later and with all obligations to the exchange cash collateralised over the interim period. There were plenty of “fails” but no real naked short selling “problem”. Hard to borrow stocks did fail regularly – but I assure you – and I have been doing this for years – when there were fails to deliver my broker called my short back and hey – presto – a few days later I had settled. If there was a “counterfeit share” it was cash collateralised and it was cancelled a few days later (in exchange for the cash collateral). The person who purchased the share from me got all the economic benefit of owning that share – and a full voting share was delivered to them within a modest time.

Fails to deliver now are – with electronic settlement – a far lesser and far quicker remedied problem than they were in the days of paper certificates. And with the speed at which they are settled – and the ability to demand cash collateral when a party fails to deliver they cause no economic problem at all.

Nonetheless the SEC took the slime-bag stock promoters seriously – at one stage issuing subpoenas to journalists who called the slime-bags for what they were. Journalists who got subpoenas – and who have considerably more demonstrated competence than the SEC include Herb Greenberg (unfortunately no longer a journalist) and Joe Nocera (New York Times).

Nonetheless in response to the well-promoted bogus threat of “naked short selling” the SEC radically tightened the delivery rules for stock. Now you have to locate a borrow before you actually short the stock (rather than having to locate a borrow before you deliver the stock) and if you can’t maintain a borrow you must cover the stock immediately – rather than fail (and pay fail-fees) for a couple of days.

Well and good you might say – but you would be wrong.

At the moment there is a well publicised arbitrage in Citigroup stock. There are four classes of Citigroup Preferred Shares which – on tendering to Citigroup – convert to common equity. And – surprise – you can buy Citigroup cheaper if you buy those preferred shares rather than buy the common. As of last night it was 18% cheaper to buy the Citigroup preferred than the common. So – with seemingly free money on the table we at Bronte Capital decided to short sell Citigroup common and buy the preferreds. An 18% return over about a month looks pretty darn good for a pure arbitrage. (So good it should not exist… its billion dollar bills on the sidewalk.)

But alas there is a problem. This deal is large - $20 billion – and as a result Citigroup common has become modestly difficult to borrow. You can’t short-sell the Citigroup common with certainty because you might not be able to borrow the shares and hence you might be forced to buy it in. And if you buy it in before you get the new (and identical) shares from tendering your preferred you could get “squeezed”. You will be forced to buy back your Citigroup stock at the same time as the other arbitragers (who have also been called on their borrowed stock) and you will pay a high price.

After paying a high price to borrow the stock you will receive your (now unhedged) new Citigroup shares at the same time as the other arbitragers (most of whom will be sellers) and – inevitably you will sell the shares then too as your plan was not to “own” Citibank. You will sell at the same time as the other arbitragers (presumably at a low price).

In the old days it would be easy. You would simply fail to deliver your Citigroup common for a few days whilst the new shares were delivered to you – and then you would deliver the new shares.

What was a perfect arbitrage has become an imperfect one.

So what you say – why should arbitragers like us at Bronte Capital be given a free ride? Well – hey we were not being given any ride – but now we are. Currently we are earning 18% on face value in a month for taking this risk – in the old days the price would have equilibrated almost instantly and people like me would not be making that money.

And that money comes from somewhere. Largely the difficulty in equilibrating the price through arbitrage makes it harder for Citigroup to raise the capital it wants. It has thus made that capital more expensive (by the bulk of our expected profits on the arbitrage).

Alas – even if you do not own any Citigroup you should be worried by this. The government is and remains the biggest holder of Citigroup stock – and when Citigroup has to pay more to raise private sector equity capital that “more” is effectively “less” for the existing shareholders. That is less for you the taxpayer.

So – in pursuing the bogus issue of naked short selling not only has the SEC diverted resources from its real job (which is chasing the real crims in the financial market such as Madoff) but it has imposed significant and real costs on the taxpayer and made it harder and more expensive for banks to raise capital in a financial crisis.

But – I should not complain. It has put a reasonable risk arbitrage our way – and I hope to report back that – thanks to the SEC crackdown on a bogus issue our clients are just that little bit richer.

Nonetheless I will know a commentator who really gets it when they defend modest levels of cash collateralised fails to deliver as a normal part of a normally functioning financial market. Naked short selling is good for markets, good for taxpayers and good for capitalism.

Quantifying the loss to taxpayers

Consider who bears this loss? There is 18% discount for buying the common over the preferred. To anyone who swaps preferred for common there is an 18% profit. As this is a 20 billion deal this profit is 18% of 20 billion or $3.6 billion.

The market is a zero sum game – that $3.6 billion is paid by someone. Well that someone is two groups. The first group is the existing preferred shareholders who should have got more for their shares. The other someone is Citigroup who get a less good price for the shares they are issuing. The incidence is hard to determine but given the recent history of squeezing shorts on preferred conversions is obvious enough that Citigroup bears at least half of the incidence.

As half of the loss is born by Citigroup who gets to issue the shares at a price that is too low. That is the loss is borne by Citigroup shareholders.

The cost to the taxpayer – well 18% of 20 billion raised is 3.6 billion. Just over half of Citigroup is owned by the taxpayer – and more than a half of that arbitrage profit comes from the issuing company (Citigroup). The cost to the taxpayer – a neat gift to hedge fund operators – is at least a billion dollar.

These days I guess that is small change. Either way – as a recipient of this gift I wish to thank the slime-bag proponents of the naked short selling hogwash.


Correction. I have been emailed to say that Joe Nocera did not get a subpoena.

Correction 2 - in the comments - if you account for the borrow cost on Citi the profits to the arb are originally about half (now well under half) of the profits indicated in this post. [We put it on with a wider spread than this. And the spread has narrowed for a few days. Also the borrow cost has been rising.] That just reallocates the profits to prime brokers - who really deserve it anyway.

The current borrow rate on Citigroup is just over 100%. We may take the trade off when the numbers make no sense any more.

PPS. The spread narrowed and the borrow rate on the Citi remained high. We covered this for a small profit. Trivial really. The biggest profit is being made by the prime brokers who get to lend out the shares.


Aaron Krowne said...


1. How is it ever good for "the market" to create phantom shares, distorting supply and demand? It seems, at minimum, the gain in ease of arbitrage is balanced by some rather heinous drawbacks (like 2x oversubscribed proxy voting, to say nothing of general downward-mispricing)

2. Rather than fully "outlaw" naked short selling, wouldn't a more level-headed solution be to make the penalties economically (but not punitively) meaningful and

3. I find it hard to believe that naked short selling is the only way that preferreds could be priced up or the common could be priced down. Can you explain why the market is "failing" here? Is it really the market, given the level of government involvement?

I think your characterization of the problem as "bogus" is unfair. I started with your perspective, but spent a while studying up on the issue from the other side (DeepCapture and other sources). After this exercise, it seems to me that a small number of operators, but more worryingly, the prime brokers themselves, were abusing naked short selling in large scale. Despite the fact that most "targets" were distressed (i.e. in need of more capital), it does not follow that they should be able to be roasted by entities that can generate infinite quantities of selling pressure; something no finite market can stand up against.

Also, specifically, it seems a realistic complaint was that under the old "penalty" structure, the naked shorts could be rolled-over indefinitely, likely in growing scale, truly fulfilling the "infinite" aspect.

If we could limit the terms, and impose some reasonable cost, that would seem to address your concerns AND solve the problem of potential long-running abuse.

Anonymous said...

Hi John,

I'm surprised to hear you think naked shorting is a good thing.

Surely agreeing to sell something you don't own (or have some right to sell) is fraud, whether it be a car, a house or a share. Granted, shares are more liquid, and no one cares if they get share 1000 or 1001, but the concept is the same.

You seem to suggest that there will be a market efficiency problem if you are not allowed to sell shares that you don't have, which are difficult to borrow. But if they are difficult to borrow, doesn't that mean that that part of the market is not efficient anyway?

In the same vein, you suggest that with Citi there is a large arbitrage but a limited supply of available shares, as other arbitragers (arbitrageurs?) have beaten you to the trade. It seems from this that the normal shorting trade is working (albeit the 18%difference still exists), but you're just upset you didn't get amongst it early.

I also don't understand (belonging to the former of your reader groups) why the arbitrage isn't reduced by people buying the prefered shares, converting them, then selling the ordinaries. If this is a difficult process, then wouldn't that justify the 18% price difference, if not then it is another (non-fraudulent) means to achieve the same end.

I regularly read and normally agree with most of your blog, which is why your stance on this topic strikes me as odd.

o. nate said...

I'm not sure your calculation of the loss to taxpayers is correct. The 18% profit to the holders of the preferred can only be realized if they have shorted the common. Since this is currently difficult to do, we can probably assume that most holders of the preferred have not shorted the common. Therefore, the total profit to arbitrageurs is probably considerably less than 3 billion. On the other side, I'm not sure how the current arbitrage opportunity represents a loss to existing Citigroup common shareholders, since the conversion price is already fixed. So the loss (which is probably considerably less than 3 billion) falls only on those who sell the preferred or buy the common before the conversion (ie., those taking the opposite side of the trade from the arbitrageurs) - not on existing shareholders.

Kimo said...

Phantom shares are a legacy of paper based trading. In an age of computerized trading, it is relatively trivial to institute a confirmed borrow prior to shorting.

The existance of phantom shares invites abuse. Given the monumental abuses in other areas of finance, who can credibly argue against the proposition, "Where abuse is possible, abuse will happen"? Eventually, abusive naked shorting becomes a race to the bottom; those that abuse the most, win.

Sir, what are you thinking.

Kid Dynamite said...

you could have used a much easier to understand example: GMGMQ! even management went so far as to caution investors from buying the stock last week - warning again that it should be worth very close to NOTHING. Too bad it can't be shorted.

The "counterfeit" shares argument is nonsense - false logic - but that doesn't mean your readers will understand. I used the sports betting analogy - think about two way sports futures markets - they are the most efficient one. The lines which casinos post which you can only "buy" and not "sell" (ie, they are only offering you 5-1 that the Sox win the World Series - you cannot LAY 5-1 - are not trued up at all.

the bottom line is that we can declare that a "share" of MSFT equals 1/10th of 1% of the company - or whatever ownership stake we want - then the value of the share is about true value - not "suppply and demand" of stock certificates (digital as they may be).

people who are short the shares just pay out the same economics (dvd's, etc)... no issue.

in case it's not clear - i agree with you that naked shorting is largely a non-issue

Alexandra said...

Well, I know what I usually call people who try to sell me something that they don't own the proper rights to.
And there is even a legal word for people who sell something and then fail to deliver.
Obviously, traders claim that they are different and excempt from these definitions for some reason. It's even part of their business model, so it must be legitimate.

If only YOU did that with a few shares and from time to time, I guess there would be no issue. However, nowadays, they are traded in millions in seconds by people and by algorithms - so the problem might be a bit bigger than you care to admit.
The potential to cause trouble is there as is evidenced by the panic of 1907 was cause by just such short selling and someone trying to corner the market.

PeeDee said...

In retrospect it has become very suspicious to me that just when it became obvious the music had stopped and many banks were left without a chair it became illegal for retail investors to short. Large institutions and hedge funds could of course continue writing OTC short instruments with market makers who were then exempted from the short selling restrictions in hedging these positions.

I think Wall Street just wanted to monopolise the gains on the way down once it was clear that was the direction the markets were headed.

So it is not surprising that market falls actually accelerated as (retail) short selling was banned.

Anonymous said...

Just a technical question. I am assume you are shorting the common to lock in the 18%. Aren't you being charged a huge negative rebate on the short common? At current rate, I have the arb at virtually zero.

Randy said...

"Surely agreeing to sell something you don't own (or have some right to sell) is fraud, whether it be a car, a house or a share."

So now all types of short-selling is fraud? When did that happen?

"Eventually, abusive naked shorting becomes a race to the bottom; those that abuse the most, win."

As a owner of many penny stocks, how am I damaged here? The answer is I'm not, you just turned a pretty phrase that's meaningless.

"The potential to cause trouble is there as is evidenced by the panic of 1907 was cause by just such short selling and someone trying to corner the market."

You just conflated two opposite actions, which one caused the panic? And why should we care if short selling contributed to a panic? It's not the SEC's job to prevent panics, it's my job, and the job of any level headed investor, to take advantage of them. Read the Mr. Market analogy by Ben Graham.

"Despite the fact that most "targets" were distressed (i.e. in need of more capital), it does not follow that they should be able to be roasted by entities that can generate infinite quantities of selling pressure; something no finite market can stand up against."

Legit companies can stand up against infinite selling pressure. Go short berkshire hathaway down to $1 per share, and I guarantee I and Buffett and many others will be taking advantage by buying.

The companies that were "damaged" by naked shorting were almost exclusively money hemorrhaging failures that deemed access to more burnable capital their birth right. In those cases you have to admit that naked shorting their stocks performs a public service, preventing more suckers from buying the sales pitch, or at least ensuring new buyers got a better price on their "investment".

John Hempton said...

In answer to the technical question:

If you want a GUARANTEED BORROW - that is one that the lender promises not to call - then the arb is zero.

If you just borrow from the inventory at any time subject to call at any time the arb is there, real and large.

If you do the trade with a synthetic (say a future) you get the arb down to zero too.

You can do it with puts and calls - but you need the call to be way out the money or you will get called on it (leaving you short physical).

If you do that you have some risk and some margin - but the further out of the money you go the worse the terms are.

The action is in the $4 call as that is far enough out of the money.


John Hempton said...

More precisely the prime broker has cranked our cost to borrow for the shares up to about half the arbitrage return.

So - as I see it half the arb profit (and all the risk) goes to us (and our clients - and half goes to the prime broker.


Anonymous said...

Hopefully a when issued market will develope when the offer is launched (sometime next week). Hopefully it is liquid enough to short and recapture some of the spread.

Anonymous said...

John, I really do appreciate that there are no sacred cows with you.

Devils advocate indeed, you must be a masochist.

How similar is this situation with the VW/porsche mess that happened in recent history. What effect did european regulation have on it?

The people who talk most about the "naked short selling" problem usually hold Europe up as an example of good regulation.

Alexandra said...

Well, Randy, I think you are a bit confused as far as the importance of your role is concerned.
I cannot remember having voted for you to take any such guardian's position and I can not find a description of such a role you claim to have in any law made by Congress.
The SEC's role is whatever role Congress chooses to assign to it. What you or Wall St. think, is only marginally relevant.

The sole thing you can exercise, is your right to trade at an exchange, according to the laws and regulations when admited to that exchange. This is a permission subject to termination or suspension when rules are violated. Nothing more than that.

And 1907 WAS caused by people going (naked) short and by someone trying to exploit that situation by forcing a short squeez - that didn't happen but the exchange crashed nevertheless.
I am pretty sure no trader has the right to cause such mayhem to others.

Masters of the Universe obviously feel they are exempt from moral and ethical standards that apply to all others.
That's why you can't see that selling something you don't own, or have no right or permission to sell, is already something considered illegal.
In addition failing to deliver that thing makes this fraudulent, especially if you never had the intention of delivering it.
This is a well recognized principle throught society and the (common) law. Except for Wall St. where such rules obviously do not apply.

Kid Dynamite said...

"infinite selling pressure" is a total myth - if i have $500MM and want to bet against the price of XYZ i should be able to do it - just like i can bet on the price of XYZ rising. naked short sales still need to be collateralized with cash, Alexandra.

the only problem is that people have been conditioned into false logic arguments like "you shouldn't be able to sell something you don't own." again - that's not how markets work. look at futures markets - there is no reason stocks shouldn't/couldn't trade the same way - you denote what 1 share represents (ie, .001% of the value of MSFT) - and then you let the buyers and sellers determine its value - simple.

if you want stock prices to reflect the truest possible valuation for a company, you should allow naked shorting.

jg said...

There is one problem with your thinking that is flawed.

You say shorting, and even naked shorting leads to an efficient market.
You also say this is in general a good thing for investors.
It can be summarized like this: we want an efficient market because it is good for us. But do we really want an efficient market?

The problem is the definition of an efficiënt market. What can be constituted effciciënt? Tighter spreads, yes that is definately efficïent. More volume, that too is efficiënt. Infinite float? Now things begin to get sketchy here.

The market is in fact not rational and it can never be. Stocks represent illusion about value, not real value.

If naked shorting is to be allowed, then other questionable things don't matter either.
What about the trading halt instituted because of the october 1987 crash? A trading halt is the definition of non-efficient market. Trading halted over the weekend is also non efficient. If there is no trading, there is no market, don't you agree?
What about pump and dump schemes? They contribute to more volume on a stock -> more efficiënt market.
Naked shorting: any liquidity is good liquidity->more efficient.

You see now where your thinking went wrong?

Don P said...

Kid Dynamite. You can take your $500M and buy puts or all manner of other instrument in order to bet against the price of the shares, but no, you shouldn't be able to naked short the shares. When you sell a share, there is an implicit 3 day delivery requirement. If the buyer buys a share, and it remains undelivered, then that buyer is a victim of fraud.

ben said...

i don't understand how this arb can be so big when it is public knowledge. if you owned citi common and were aware of the prices and conversion shouldn't you sell it and buy citi preferred. i guess this shows how important short selling is because even when information is public and actors can profit prices still don't necessarily move.

Anonymous said...

Kid Dynamite said..." if you want stock prices to reflect the truest possible valuation for a company, you should allow naked shorting."

On that subject, wouldn't it be fun to Naked Short the US dollar! Imagine the beneficial results of bringing US currency in line with its fundamentally more equitable international value. Mankind as a whole could benefit henceforth as the lessons of Rome play out again. I figure just a few trillion more conterfiet dollars dumped into the already burgoning Obama trillions would be enough to undermine public confidence locally and abroad. Oh, but wait, the US's economy is built with steel and concrete -- a pillar of fundamental strength that no speculative market manipulation could affect. Wouldn't it be fun to Naked Short the US dollar!

John Hempton said...

Oh, there is a phoney argument...

Yes you can short the US Dollar. It is cash collateralised.

I have yet to find me a broker who will allow me to sell ANYTHING short and not deliver it without cash collateralising my obligations...

I love how the naked shorting crowd just makes it up.


Anonymous said...

"Yes you can short the US Dollar. It is cash collateralised."

Let's get our terminology clear... We are taking about "Naked Shorting" not Shorting! I am surprised that you of all people would misleadingly interchange the two terms. Applied to the US dollar, wouldn't Naked Shorting be analogous to currency counterfeiting? Many cash collateralised CDOs market values have collapsed. Why would the US dollar be different?

"I have yet to find me a broker who will allow me to sell ANYTHING short and not deliver it without cash collateralising my obligations..."

You're probably just not looking for such a broker in the right places. It's not like the world hasn't seen enough of them. Otherwise, you have the option of becoming one yourself. The world is full of people that spend 24/7 trying to cheat others and stock counterfeiting through naked shorting has proven to be just one of those methods.

"I love how the naked shorting crowd just makes it up."

Err... no, I would best fit your drywaller category.

Anonymous said...

maybe I should be able to buy phantom shares at the market price even if they are not available for sale?

when a stock is thinny traded small volumes can cause large movements becuase of no liquidity available. i.e no one wants to sell at that price.

so sometimes its hard for big players to come in at low price.

conversely naked short selling is like printing money ... i.e. shares. these dont exist but are made to exist!! this is very very wrong. becuase the price is no longer a reflection of what price people are willing to sell at, but rather a reflection of what price the short seller thinks they should be trading at

Anonymous said...

maybe we should be allowed to do naked long buying. i.e. we should be allowed to buy shares at a price of our choosing and "create" these phantom shares and go long on them. how about that?

Anonymous said...

I'd like to Naked Long me a Toyota Prius!

Anonymous said...

good article

dede said...


This is a comment on your post dated June 16, 2009. Sorry for the delay but I discovered your blog recently and this is the post I disagree with so I shall try to be smarter than you for once.

Some comments point out that when you sell a stock, you promise to deliver it after three days, so if you do not, you breach the contract and this is simply against the law. However, laws can be stupid: I shall attempt to explain why this one is not.

Let's take 4 investors IS, IL, IA and IB and their respective brokers BS, BL, BA and BB. there are two stock S1 and S2.
IS sells S1 to IL at 100
IL sells S1 to IA at 110
IB sells S2 to IL at 110

After three days:
- IS is naked short so BS cannot deliver
- IL has 100 cash at BL
- IA has 110 cash at BA
- IB has S2 at BB

First option :
BS does not deliver to BL who therefore does not deliver to BA, there is 100 cash at BL and 110 cash at BA, unfortunately, BL needs 110 to receive S2.
Fortunately, BL can extend credit to IL for 10 and the delivery is square between BL and BB.
However, BL fails on its delivery to BA and IL is a debtor to BL for 10 : your failed delivery has created some credit risk and some market risk for both IL
and IA, this is hardly fair (and somebody will bear some costs).

Second option :
IL is called Lehman Brothers and it is Monday 14/09/2008. BL is not financing the 10, absolutely no delivery occurs and IB does not get their 110 : your
failed delivery has broken the system entirely and IB goes bankrupt as well because they needed 110 on that day.

Multiply the case as much as you wish (adding investors, brokers, custodians, crooks and transactions) : failed deliveries remove securities liquidity as
well as cash liquidity and constitute a systemic risk. The regulator is right to try an mitigate that risk (the argument on the solvency of the company S1 is nonsense indeed and misses the point).
Naked shorts increase the systemic risk of failed deliveries : banning these decreases that risk and the regulator is right to do so.

Moreover, your example on Citibank illustrates that risk perfecly : if it was possible to make 18% arbitraging the common against the preferred, this is because there was no liquidity in the security (the government does not lend to short sellers and is not supposed to arbitrage himself while other
shareholders had lost so much money on their Citibank holding that 18% on the remaining value was not worth the fuss or the brokerage costs). There were
barely any lenders around so the arbitrage was costly to put in place but if you had been allowed to naked short, you would have failed the delivery until
the preferred was converted and the systemic risk was on for that period.

Indeed, this does not apply to shorts where you can borrow the stock : this adds liquidity and is in no way a systemic risk (some exchanges banned these ones
as well and this was wrong)
Also, this is not true on derivative markets because there are margin calls (at least daily, ideally intraday) to mitigate the cash liquidity risk and the
settlement being in cash, this removes the problem of liquidity on the stock (the margin calls from your Prime Broker on the equity markets are not passed on
to the market : they only cover their risk against you).

Comment on the side : I really do not understand lenders because they are increasing the downward pressure on the price of their own assets by increasing the pool of sellers. This is good for the liquidity, good for you and bad for them (even if on this case, they shared some of the 9% you gave to the broker - they should have made 18% doing the arbitrage themselves!) : I think they are fools but the regulator is right to let them do that because this mitigates the systemic risk.

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