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Comment by jaycroft | Hacker News Reader

And just for completeness on your comment, a naked short is the same as a regular short, but in the opposite order. First sold short, then borrowed after the fact.

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I can’t quite wrap my head around how this is possible.

Are stock brokers allowed to just generate shares in their computer systems and then find a way later to actually obtain them? And when they do so, that might actually be from another broker who magicked them into existence?

Because actual delivery does not happen until settlement time three days later. The seller has until then to acquire the shares.

Naked shorting is illegal. To short the shares the seller only has to perform a “locate” first. That involves contacting someone that has the shares and is willing to lend them. Skipping the locate step is illegal. They just don’t have to actually borrow them until delivery.

Additionally, if the locate fails to materialize then it’s the sellers responsibility to borrow them from someone else before delivery. If not, that leads to a fail to deliver which locks up further transactions for the seller until it’s resolved.

Thanks, that’s a bit clearer now.

>Naked Shorting is illegal.

Unless you're a market maker and thus exempt from the regulation, because your market making function requires buying and selling lots and lots of unsettled shares in order to provide liquidity.

I'm curious if you have any more information on this, not in a snarky way, just curious.

Sorry it took so long to get back to you with an answer! Also no snark detected. Here is a nice overview by the SEC but it's really light on the details.

https://www.sec.gov/investor/pubs/regsho.htm#_ftn4

You can also look through FINRA's regulations here:

https://www.finra.org/rules-guidance/rulebooks

The wikipedia article on Regulation SHO is also fairly relevant:

https://en.wikipedia.org/wiki/Naked_short_selling#Regulation...

It's pretty long and tedious and not really targeted to your question though. I'll try to remember to post a better resource here when I find one.

That last part is what really confuses me... what if the seller never resolves the failure to deliver? The buyer is walking around believing they own a share that the seller never actually gave them... I understand that the types of institutions that can engage in this behavior will true up their balance eventually, but why allow it in the first place? I can understand playing fast and loose with derivatives, since they are created out of nothing anyway, but securities should be treated in a manner consistent with their name.

Same as if you pay for ten tons of lumber and it doesn't show up. Stock trading grew out of traditional property trading and inherits a lot of its norms from there.

Does it have to be that way? Everything is electronic and stocks can move at the speed of the network whereas lumber cannot.

There could be some archaic processes that are not electronic but are there inherent good reasons why they cannot be converted?

Not necessarily. But we're talking about a heavily regulated system, run by a lot of very conservative entities, that currently works pretty well on the whole; there's going to be a whole lot of "if it ain't broke don't fix it".

I guess this is where the sentiment of "let's break it so they fix it" comes from.

The buyer gets made whole by the broker they bought from, retail you'll never know it happened. The buyers broker makes the sellers broker make them whole, they pay whatever the buyers broker has to pay to buy the shares elsewhere plus more. Brokers

That's what the clearinghouse is for. They are the counterparty for both sides. So the seller's counterparty is the clearinghouse, not the buyer, and the buyer's counterparty is also the clearinghouse. The clearinghouse requires broker margin accounts so that they can close out a trade when there's a failure. And the amount of collateral depends on risk.

(This is also why GME trading was halted by some brokers--assymetrical trades and increased volatility meant there was greater risk for trades in those stocks for those brokers, so the clearinghouse demanded more collateral from the broker. Broker doesn't have that collateral right away, they can't make the trade.)

It sounds devious when you put it like that, but yes. Most things in finance are compositions of credits and debits that take time to settle. The aim is to have sufficient liquidity and price accuracy that the time between executing and settling is safe, but there's always risk that things go awry before the settlement.

Trades aren't settled immediately. Finance runs on various forms of promises, basically.

I’ve never heard a simpler statement of the fundamental Achilles’ heel of modern finance: “various forms of promises”

The system has become so intertwined that when someone breaks a promise, it’s too disruptive to actually hold them to account so we just paper over it to keep the wheels of commerce rolling.

Which is a form of hostage negotiation. Promise breakers are incentivized to profit as much as possible from broken promises as long as they can hold the system as a whole hostage.

Not sure this analogy answers your question, but it might help:

https://news.ycombinator.com/item?id=25944738

Yes, it’s like writing a check that won’t clear because you know it’ll be a few days until the money comes out of your account and even if it doesn’t, you can say “oops my bad” and fix it later.

Not necessarily. As long as the borrower commits to borrow the stock at a determined point in the future which the broker legitimately deems should have borrow liquidity (availability of shares to borrow), the short sale is not naked.

And interestingly enough, if this transaction occurs in good faith and for unforeseen reasons there is no borrow liquidity at the agreed upon time, a fail to deliver will occur despite the short sale not being naked.

That's fair - said another way you just have to have a plan in place to borrow the share but don't actually have to have it borrowed yet. And all this discussion is fairly moot given the number of shares that routinely fail to deliver and the general lack of meaningful enforcement actions.

That... seems gimmicky. Like using repurchase agreements to pretend that your balance sheet looks cleaner than it actually is.

It's not really about presentation of balance sheets, it's about liquidity. The explicit purpose of market makers is to provide liquidity, so they have a special exemption to buy and sell shares without being certain they exist. They have to have a good faith belief they will exist though. Usually they're right. Occasionally they're wrong.

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