Getting naked: in praise of naked short selling

Photo by Spencer Tunick, Netherlands 8 (Dream Amsterdam Foundation) 2007 [link]

If short sellers are considered to be the Mussolinis of the financial market, then naked short sellers are its Hitlers.

In this post I'll show that naked short selling isn't solely a hedge fund or equity market phenomenon. In fact, the good old fashioned practice of deposit banking amounts to what is essentially naked short selling, thus making staid bankers, and not hedge funds, the world's largest naked short sellers. This means that anyone who vilifies the naked short selling of equities must also be against the common practice of banking—a crack pot position if there ever was one.

Short selling is when an investor borrows shares of, say, Microsoft, then sells those shares in the open market. At some point—either at the lender's behest or the investor's—the borrower will repurchase the shares in the open market and return them to the lender. A short seller hopes that the price of Microsoft has declined in the interim so that when the time comes to repurchase them, it will cost less money, thus resulting in a profit to the short seller.

Naked short selling is similar in every respect save for one: when our investor sells Microsoft shares short in the open market, they do so without borrowing those shares ahead of time. (To get more specific, read this SEC page)

Which sounds odd, right? How can someone sell something if they haven't either purchased it or borrowed it ahead of time? No wonder people wrinkle there noses at the practice of naked shorting—it seem like sleight of hand!

The best way to think about naked short selling is to turn to banking. Why? Because bankers engage in short selling every.single.day. Just as an equity short seller will borrow and then sell Microsoft with the intention of repurchasing it at a better price, bankers borrow and then sell dollars with the intention of repurchasing them at a better price. Apart from the respective instruments involved, dollars vs stock, there's no difference between what an equity short seller and banker are doing.

So if bankers engage in short selling, do they act as mere regular shorts sellers or do they get naked?

In the previous paragraph you may have noticed that I described banking as the borrowing of depositors' dollars in order to lend those dollars out. Because the dollars were borrowed prior to sale, this would qualify their activity as regular short selling, not naked short selling.

But hold on, this isn't at all how banks function. Bankers don't wait for physical Federal Reserve dollars to be deposited by the public before selling them away—they short dollars whenever they wish, creating electronic deposits out of nothing in order to buy things like bonds or personal IOUs. Banks are engaged in naked shorting pure and simple: they sell a financial instrument that they never actually had in their possession.

How do they do this? The key here is that banks don't actually sell Fed paper dollars short, rather, they sell dollar-linked IOUs (i.e. deposits) short. A deposit is a claim on the bank's capital that mimics Fed paper dollars by being indexed, or denominated, in terms of those paper dollars. It's similar to a Fed dollar, but it's an entirely different instrument.

Circling back to naked equity short sellers, the same thing is occurring when a naked short is initiated. The instrument that they are selling short isn't a Microsoft share, but a newly-created IOU that is denominated in Microsoft shares. It would be as if I gave you scrap of paper with the words "I owe you one Microsoft share" on it. Rather than buy a real share, you could just hold the IOU I gave you. The instrument would look like a share, walk like a share, and even circulate alongside shares, however it would be an entirely new financial instrument.

This ability to "print" new IOUs denominated in terms of Federal Reserve dollars (in the case of the banker) or in terms of Microsoft shares (in the case of the short seller) often results in a quantity of derivative units that far exceeds the underlying issue of base units. We get an inverted triangle of sorts where on top of a narrow base of Fed paper dollars is arrayed a much larger quantity of dollar-denominated deposits, often 10 or 20 times more. Likewise, the number of Microsoft-denominated IOUs that naked short sellers create may eclipse the number of actual Microsoft shares outstanding.

It is the naked short seller's possession of a so-called printing press that draws the wrath of CEOs. The accusation is that a hedge fund can make a good profit by manufacturing and selling massive quantities of Microsoft-denominated IOUS in order to drive Microsoft's stock price down to zero, thus benefiting its short position. Emblematic of this belief is the battle waged by Overstock CEO Patrick Byrne against short sellers who had been engaging in naked selling of his firm's stock, which had fallen on hard times. As early as 2005, Byrne accused short sellers of creating a fake supply of Overstock shares (at one point reputably six times more than actual shares issued) in order to drive its price lower. Byrne went so far as to launch several lawsuits against the perpetrators.

How legitimate is Byrne's concern? Let's return to our bank analogy. Is there anyone who would argue that because banks can create and short deposits willy nilly, they'll drive down the underlying Fed dollar's price towards zero (ie. create hyperinflation) and thus earn outsized profits? Of course not. Banks in the U.S. and Canada have been creating deposits for centuries without causing hyperinflation. It simply isn't a concern because the issuer of underlying dollars, the Federal Reserve, stands ready to support the value of the dollars it has issued. It can provide this sort of anchor because it holds a variety of assets that can be mobilized to repurchase and cancel paper dollars, thereby removing any excess supply that might emerge thanks to competing issues of dollars by banks.

Likewise, if naked short selling creates a glut of Overstock IOUs and begins to drive down the price of Overstock, then in the same way that the Fed can deploy its assets to remove the supply of Fed dollars to stabilize their value, Overstock's Patrick Byrne could have used his firm's assets to repurchase stock. If he chose not too do a buy back, one might wonder if his company had the assets on hand to begin with.

To sum up, in the same way that bank issuance of dollar-denominate IOUs cannot drive the purchasing power of underlying Fed dollars down as long as the Fed has sufficient assets and chooses to use them, neither can naked short sellers drive Overstock prices down if the company has sufficient assets and is willing to conduct the necessary repurchases.

So haters of naked short selling, are you consistent in calling for an outright bank on banking? You say that naked shorting drives down stock prices, which means you no doubt also believe that banks inevitably create hyperinflation, right?

Addendum:
JKH has a post on the topic here, the Full Monty on Naked Short Selling.