Naked shorts – and failed trades.

Whenever markets are in the doldrums, it happens. The rise and rise of those using shorting strategies is making regulators ask themselves whether there is sufficient transparency around the transactions. Especially the so-called ‘naked shorts’.

In this, those selling securities short do not secure the stock for delivery. In a typical short-sale transaction, the seller borrows a security and then sells it, with the goal of purchasing it at a lower price in the future and pocketing the difference. Critics say those pursuing naked shorts are essentially creating phantom shares to sell and drive down a stock's price.

So regulators are now looking at how this process works and consulting on rules changes.

In the US, where naked shorting is in fact illegal, the SEC has Regulation SHO, which went into effect in 2005. Broker-dealers must borrow the security, have entered a bona fide arrangement to do so, or have reasonable grounds to believe the stock can be obtained before settlement.

Under Reg SHO, broker-dealers are permitted to accept customer assurances that they have identified a source of borrowable securities. "We are concerned, however, that some short sellers may have been deliberately misrepresenting to broker-dealers that they have obtained a legitimate locate source," said the SEC in its proposal on beefing up SHO, published on March 21. In general, Reg SHO has done a good job of making the data surrounding these issues public, But, said Chairman Cox. “ the time has come to give it some enforcement teeth”.

Meanwhile, in Australia, the recent market turbulence had led to Treasurer Wayne Swan to call for laws clamping down on volatile share-trading techniques that have been driving down the value of superannuation funds and other stocks. He promises that "the Government will pursue legislative change to address the ambiguity around covered short-selling and disclosure."

And the ASX in a new consultation is proposing some immediate measures on increased transparency.

Back in 2002/3, in the aftermath of the internet bubble. the FSA did its own enquiry. They concluded that they did not need to make any rules changes, but in late 2003 CREST (Euroclear) started publishing aggregated data on the per-stock short selling.

Add in changes in the last month in India, Canada…and we have a picture of increased transparency on the levels of covered – and naked – short selling. Which those responsible for keeping tabs on whose holds their company’s shares will welcome.