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Comment by woopwoop | Hacker News Reader

The author seems to be really upset about this, but I don't understand why. Nothing they are describing, if you ignore histrionic language like "counterfeiting", seems especially nefarious. Maybe I am misunderstanding. Basically, a short is when A borrows from B a share of corporation C with the promise to return a share of corporation C at a later time, plus some cash interest. A naked short is where instead B gives cash equal to the value of a share of corporation C minus some interest to A, with the promise that at a later time A will deliver a share of corporation C to B. The second activity seems functionally equivalent to the first, and I don't understand why I'm supposed to be outraged by either.

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When I purchase a stock, I do it in the express belief that I will get a physical (though digitally stored) share of that company, and possibly one that gives me a voting right if the stock is marked as such. When a stock “fails to clear” this gives me a ton of problems such as slippage and volatility, and possibly a quite substantial loss.

Same if you buy an apple, I'm sure you'd only do it in the belief that you will actually get something edible. If I got nothing, I'd want my money back! But then when you buy an apple, you can see and touch it before you commit. Not so with stocks. And so you buy it while trusting the broker that your order will actually be met.

If instead my money is “borrowed” without my concent for some nefarious activity—in order to create more “liquidity”—that has a name: It's fraud. It's fraud of the customer whose money is being stolen. It's fraud of the customer who's being fooled into thinking that he's buying a real stock. That these shares do not exist, isn't some slip-up. It's an intentional effort, done with the motive of earning money by exploiting the trust of their customers. Such action should thus clearly be illegal.

Same if you bought a stock, and your broker suddenly decides to steal it without your knowledge, and loan it out in order to sell it in the hopes of earning money if its value drops (i.e. short the stock). Clearly you'd want to know if your property is being loanded out, because it means that you're incurring risk, no matter if you're compensated for it through interest or not.

If I want insurance to protect against the price going down, I'd buy a put option. I know a bit about this but I'm not an expert on this. Naively, those put options are effectively offered by those providing a short (they think the price is going to go down, or have a way to hedge the price decrease). Those don't get represented as shorts either. https://corporatefinanceinstitute.com/resources/knowledge/tr...

The other thing to consider here: if some entity needs to provide the put option, how does one hedge (risk manage) a put option ? They need to consider what would happen if the price drops, and as the price drops their hedge needs to increase in price. There's undoubtedly more to this, but that relationship sounds awfully like a short.

Any experts want to wade in here?

Options are bets in a way that actual sales aren't. Notably, a put explicitly a contract to sell something at a given price in the future. Nobody buying or selling a put has any intention of stock trading hands -- and the option can even be written as cash-only, where stock never actually does. So while selling a put is the same fundamental idea as a short ("I think the price will go down"), it's mechanically very different.

A short sale is something very particular: it's selling something you're borrowing. The counterparty has actually bought a stock. Not an option, he can hold that stock for sixty years. This is fucking weird.

You know that a put and a call combine to make a synthetic stock? See https://en.wikipedia.org/wiki/Put%E2%80%93call_parity

(If you write a put and a call for the same strike, you are basically in the same position as a short seller. If you buy a put and a call for the same strike, you are economically in the same position as an owner of the stock.)

Hence, you can't separate options from stocks.

This is not entirely accurate. It is the same position as borrowing some amount of money to buy the stock. If I buy a put and call and the price at expiry is exactly that strike I am guaranteed to lose money.

Agreed. One of the reasons is that the option has a risk and therefore there's a cost associated with managing that risk and taking on the trade.

Not quite. It's the 'risk-free bond' term that I dropped from my explanation of the put call parity.

To replicate the stock, you'd buy the call and sell the put. The risk exactly balances out in the sense that a total portfolio of 1 stock short, 1 call long and 1 put short would have zero risk and behave like a risk-free bond.

(If the risk premia of the long call and the short put would not exactly balance, you could make money with very simple arbitrage trades.)

Yes, my explanation dropped the bond term from the put call parity.

Economically, sure, but not literally. If you hold both a put and a call, for instance, you can't vote with them, or earn dividends. You would not say you're the actual owner -- whereas a short sale creates a negative actual stock.

And that's why voting rights get special treatment in share lending. Dividends are also handled by share lending agreements.

When we talk about naked shorts, they would still have to be covered before delivery (usually two days after the trade).

And when buying a normal stock, not from a short seller, you also can only vote once you take delivery. So everything is the same.

> selling a put is the same fundamental idea as a short

Selling cash secured puts is risk equivalent to covered calls, but doesn't require stock. If anything it's a neutral/bullish strategy since max profit is above the strike.

I agree on the mechanism. If the objection is that someone can influence the price of an instrument without owning it (like in short selling (although in short selling you can borrow the instrument and then short it)), then should the argument be that put options should also not be allowed without ownership of the underlier too?

My objection is that synthetic stocks are weird, negative ownership is weird, and every time we have to actually count how much stock we have we come up too high. This doesn't happen with puts.

I don't know if you are aware of this, but you are basically arguing against the idea of fungibility in finance. It's one of those fundamental concepts that banking is built on.

It's one thing to argue for making sure shorts are well-regulated, but this something entirely different that has the risk of fundamentally breaking our society.

Cash is fungible, but it's unclear whether stocks should be fungible in the same way.

Our financial markets are built on the idea that the assets being traded (in each individual market) are effectively fungible. It's the underpinnings of the whole structure of finance.

Companies are allowed to issue non-fungible shares.

Eg it's common in some tech companies to give the founders super-voting stock that reverts to normal stock on sale.

Yes, but assets that are traded within a particular financial market is fungible.

When you buy a share from the open market, they are not going to guarantee a particular share with a particular serial number you specify, they will only provide a number of that particular class of share of the company.

Well, only fungible shares lend themselves to be traded on financial markets.

Most companies decide to make their shares fungible, because they want them to be readily tradable.

But there's no one forcing anyone here. Companies and investors could agree to shares with particular serial numbers.

It's just so much more convenient to have fungible shares, that this is where all the capital goes.

I don't think he is arguing against fungibility. In fact, he compared stocks and cash under the assumption of fungibility.

I think he is arguing against the idea of applying fractional reserves to brokers.

Yeah, that's what I thought the argument was until this bit -

> Same if you bought a stock, and your broker suddenly decides to steal it without your knowledge, and loan it out in order to sell it in the hopes of earning money if its value drops (i.e. short the stock). Clearly you'd want to know if your property is being loanded out, because it means that you're incurring risk, no matter if you're compensated for it through interest or not.

I can't find any other interpretation for this logic and terminology other than a rally against fungibility.

That has nothing to do with legal fungibility, and everything to do with property rights, and the conditions at which most people expect to buy a stock (licensing notwithstanding). Fungibility is merely how easily the medium is broken into smaller parts that may be exchange for convenience, and not the regulated use of third parties, unless you're really talking about liquidity. The latter can easily be solved with waivers or contractual agreements (such as an opt in). As far as I know most brokers already do that, but the implication is that some don't or are somehow able to sidestep such regulation.

>Fungibility is merely how easily the medium is broken into smaller parts that may be exchange for convenience

No, fungibility is whether an asset (ie. individual assets within a particular class of asset) is interchangeable with one another.

It means when you deposit banknotes into your bank, whether the bank has to give you the same banknotes with the same serial number, or whether they can give you equivalent instruments to satisfy their obligation to you. What they owe you aren't the banknotes, but instead the money.

Also note when you deposit money into a bank, it's not treated the same way as if you put banknotes in a safe deposit box. The way you made your argument on stock brokers is as if it is, and fundamentally misrepresents this relationship. They don't owe you 'your' shares, they owe you a number of shares. Your shares become their asset, in exchange for their liability to you. You don't get to control what they do with their assets.

That's also the reason you don't get to control what the bank does with 'your' money you hold with them, because legally, it's their money with an obligation to pay you when requested. Hence the central bank steps in to regulate and guarantee fractional reserve banking in order to prevent bank runs.

> Fungibility is whether an asset (ie. individual assets within a particular class of asset) is interchangeable with one another.

Of course. This is synonymous with my own explanation. However your take is that it means that after you've made it interchangeable, then the bank or exchange somehow automatically gets more rights over it. That just isn't the case. Unless there's an express prior agreement, it's also morally wrong.

> Same if you bought a stock, and your broker suddenly decides to steal it without your knowledge

You have agreed to it at some point. If your broker doesn't give you a choice you may go to another broker.

That is a generic and ideological objection. If that was the case we would never need any regulations, just T&Cs. I get that some people believe that, but equally some people believe such a world would have way too much friction.

This is not a generic and ideological objection.

This is an explanation of how it does actually work.

The brokers I have experience with either propose you to participate in a share-lending program with profit sharing (opt-in) or propose two different kinds of accounts and you can disallow lending but then the conditions are slightly worse (some fees are waived if you let them loan your shares).

The shares are not "stolen without your knowledge". If you're using margin it may be part of the conditions attached to that. Would you say that a broker liquidating part of your positions to satisfy margin requirements is also the broker deciding to steal your shares without your knowledge?

A lot of things look like cheating, when one only skims the first page of the rule book and then plays.

Yes, it indeed a good argument against most regulations.

However, this argument does not apply to regulations that lower barriers to entry, because low barriers to market entry are exactly what enables competition.

(Most regulations, alas, raise barriers to entry. Even if that's not their intended purpose.)

Of course that's a fiction, almost all stock in the US is owned by Cede & Co

https://en.wikipedia.org/wiki/Cede_and_Company

All you own are assignments of that stock

I don't thinks this interpretation of 'owns'is accurate, but if it were, it would be even worse than the original allegation!

I believe that apart from legacy certificates in a lockbox under grandma's bed (and non-traded private classes of stock) it is actually true.

What DTC trades are assignments of stock held by Cede corp, what you own are assignments of assignments held by brokers - it's how you take physical stock certificates and start trading them electronically (back in the 60s)

> If instead my money is “borrowed” without my concent for some nefarious activity

You give stock borrow consent when you sign up for a brokerage account. It’s also trivial to turn off, though there isn’t an informed reason for non-activist investors to do this. Some brokers share stock loan income with the account holder, though most keep it from retail accounts.

This is a perfect compendium of the flimflam put out by those who object to short selling.

'a physical share' No. There's no such thing. Even a physical share certificate is not a physical share. It's a physical piece of paper which documents a nebulous thing - the set of rights you have, and terms between you, the company, its management and other shareholders.

'slippage and volatility'. No. You bought the share at the price you were filled on. No slippage. One share gets lent out, one share gets returned. You are not affected by volatility in any way, because the share your get back is exactly the same as the one you lent, and the price change would have affected you anyway.

'A substantial loss' When a share your broker lent out fails to deliver (which you would never know about), the broker doesn't write to you and say 'oops, your share didn't make it back, your loss'. First of all they didn't write your name on the same before they lent it. They have a bunch of shares which they lend out. Secondly, someone will have to produce either the share or the exact amount of money required to buy an identical share at some point. Thirdly, even if they didn't, the broker would make good any loss, whether inadvertent or due to some mysterious malfeasance. That's literally the reason your broker holds capital and is regulated.

A share is not like an apple. You buy a share with the clear intention of selling it to someone else one day. It's a speculative activity par excellence. People who buy apples in order to trade them are generally quite comfortable with the fact that 'their apples' are in reality just a binding contract on someone else to produce those apples when asked. In the same way, the bank does not have 'your money' in a pot somewhere. They just promise to produce it under certain conditions, and there are regulations making sure they keep this promise. I get that some people think this in itself is suspect, but if so, you are opposed to most aspects of modern finance, why pick on short sales?

If you buy a share, your order to buy one will most definitely be met. They can't lend out something that hasn't been bought. You might be confusing short selling with another bugbear, order internalisation and PFOF.

> If instead my money is “borrowed” without my concent for some nefarious activity

What activity? Who is borrowing your money?

> whose money is being stolen Your money was used to buy the share.

Want to sell the share? It's there. Want to vote the share? It's there provided that you actually paid for it with cash. Oh, you bought the share on margin? Well, the same as a car which you borrowed money to buy, the share does not fully belong to you in those circs. So depending on the rules, you might not be able to vote it.

> That these shares do not exist, isn't some slip-up. The share definitely exists. Allowing retail investors to bet on shares going up and down without any actual shares trading hands is illegal, since the 1930s.

'without your knowledge'. Everyone knows about this. That's literally why we're taking about it.

>loan it out in order to sell it in the hopes of earning money if its value drops The broker doesn't earn money if its value drops. They lend out a share, they get back an identical share.

>Clearly you'd want to know if your property is being loanded out, because it means that you're incurring risk

No more risk than the general risk that your broker (or bank) will fail, that the regulator got it wrong and they don't have enough money to pay everyone back, and that the govt won't step in if this happens.

And you do know.

And you are allowed to ask them not to do it. If you paid cash for the share.

Oh, you bought the share on margin? So the broker stole someone else's money from their pot at the bank where they thought it would be taken care of, lent it to you for nefarious activity, and you spent their money on a share you couldn't afford yourself, with the express intent of making the price go up? Shouldn't that be illegal? No, margin investing is conceptually very similar to short selling and is also an accepted part of modern finance. The broker lends you money, you buy a share, you hope it goes up, when you sell the share you pay back the money. The broker lends a short seller a share, they sell it, hold onto the money, hope it goes down, when they buy back the share they give it back to the broker.

There are tons of problems with finance and financialization in modern society. This isn't one of them.

You can instruct your broker to explicitly not loan your shares out.

In some cases they’ll pay you to allow them to loan it out. You can reject this if you want.

Brokers ask about this during the signup process. It's not buried in the TOS or turned on by default without ever asking. My broker devotes an entire page of the signup process to it, and it's easy to decline.

> When I purchase a stock, I do it in the express belief that I will get a physical share of that company

When you put money in a bank, acquiring interest, you no longer control that money, the bank is free to invest it, though obligated to return it. This is part of your agreement with the bank.

When a broker buys stock on you behalf, there are often similar arrangements in the T&Cs. Your stocks therefor, cannot be borrowed, or sold, without your consent; but you need to read the terms to see what you are consenting to.

I'm not sure you read the article. Author is alleging the prime broker/clearing house system regularly "gives out" shares to sell on the market (diluting company's shares) with no transparency in the reconciliation because the main clearing system is privately owned. You're better off reading the full article since my summary is extremely surface level.

> with no transparency in the reconciliation because the main clearing system is privately owned

The DTCC provides extensive reporting to market participants, including issuers [1].

[1] https://www.dtcc.com/settlement-and-asset-services/issuer-se...

A daily report is 9450.00 USD per year per security as far as I can tell.

https://www.dtcc.com/settlement-and-asset-services/issuer-se...

9.5k a year a stock with no way to verify what they say.

Also, it's DTC, not DTCC. The inter-company loopholes still apply, not to mention all the international shenanigans.

You are a company looking to raise money through the public markets.

You have issued 10 million shares; but the market is trading with 15 million because of counterfeit stocks.

The bankers and the hedge funds have got to dilute you; actively hurting your fundraising ability, and of course; your stock price (which you may own as a founder).

This doesn't distinguish between shorting and naked shorting. But in either case I don't understand why I'm supposed to be upset. Is it because the stock price goes down?

Does it matter? 1 stock = 1 stock. 1 stock should never be 2 stocks.

It’s because I believe in ownership of what you make. If you founded a company, sold 10% on public markets for float, and magically 20% of your cap table now exists on the NYSE; something is horrifically wrong.

And yes, you would have suffered negative financial outcomes because of the counterfeiting.

There’s not just “1 stock.” Let’s say: A loans a share to be B who sells to C who loans to D and so on. You end up with a multiplier on nominal stock, always, and that’s perfectly normal. I really don’t understand the moralistic argument here, esp. without regard to the underlying value of the original asset. Up is not strictly good.

No matter how many times it gets repeated in the thread it is still nonsense made up by the stock market. Exchange "Share" with "Burger" and see how many Burgers you can create from thin air. If you end up with more than one you should start a McDonald's competitor!

If you can't it is because you are making mental gymnastics as soon as the word is some magical word Wall Street made up. Sure it is correct that you can but it shouldn't be and can't be fixed fast enough.

But thank you to everyone who gave me GME money with their mental gymnastics <3

Ok, I've done it. I told my children that I'm going to take them to McDonald's tomorrow evening. They see this promise as 100% good, as real as if they were actually holding the burger. The only difference from their point of view, is that if they were holding a physical burger now, by tomorrow evening it would be cold and bad to eat. The ones I have promised them are real burgers which are deliverable tomorrow evening, at the time we're going to want to eat them. So I've created two additional burgers owned by my children, in addition to all the physical burgers that currently exist, which are owned by either McDonald's, if they haven't been sold yet, or by customers if they have.

Does this mean that I've found an infinite supply of free burgers and should go into competition with McDonald's? No. Because I'm going to have to buy the burgers from McDonald's to supply to my children. They own two new paper burgers, but I'm short two burgers. So the net total world supply of burgers is unchanged.

Well you're still flawed if you scale your argument. What if you take your argument, and scaled it up. What if you promised each kid 1 trillion burgers. Will you have access to 1 trillion burgers tomorrow? What if they take their future 1 trillion burgers and sell half. What if you walk into McDonalds to claim the 1 trillion burgers. Does McDonalds have 1 trillion burgers? No.

So you're saying it's okay to promise burgers as long as it's an amount that actually exists and McDonald's can fulfil it. So what you're saying is that you shouldn't sell things you can't possibly fulfil? Hence the argument against this kind of trading.

Most financial institutions need some kind of basis for a promise - something that "secures" the contract e.g. like a loan secured by an asset.

A regulated entity might have capital requirements which would limit the no of burgers promised to money held. Another might be a contract with mcdonalds for N burgers, or a warehouse full of burgers - shorted stocks require the lender to actually sell a stock, and the shorter to actually sell it (and buy it back later) but there will need to be security/"deposit" on the returning of the stock - there exist a risk that the lender will not get their stock back, which is part of the reason for the premium.

Since you/I are not regulated financial institutions, not may would trust us to deliver 1 trillion burgers on paper; so the flaw exists in "What if they take their future 1 trillion burgers and sell half" - sell to whom? They'd have to find someone willing to buy. "What if you walk into McDonalds to claim the 1 trillion burgers" - the "paper burger" is an agreement between you and some third-party, not mcdonalds. You couldn't pre-order items from one shop, and go to another store with you invoice and demand they fulfil it - your contract is not some general/official currency, there is no obligation to accept it.

> So you're saying it's okay to promise burgers as long as it's an amount that actually exists and McDonald's can fulfil it.

It's a promise that you will supply N burgers, so the criteria for ok-ness is that you can supply N burgers, that McDs can provide that many is necessary-but-not-sufficient alongside:

- you can pay for N burgers - you can transport N burgers (on time)

but when I say "ok", I mean from a "morality of making personal promises" perspective, not "financial promises/obligations made by a regulated financial institution" perspective. Individuals are not financial institutions, and financial institutions are regulated as such.

Person A has burger. Person B borrows A’s burger and sells it to Person C.

Person D borrows Person C’s burger and sells it to Person E.

Still seems to work? Then, tomorrow Person B and Person D owe burgers to Person A and Person C.

If there is only one burger in existence, this will create demand pulling prices up I’d think.

This is where the burger analogy breaks down in my opinion because it's a lot harder to deliver a fraudulent burger than a digital signature.

What can happen in real life is Person A and Person C are given a digital receipt confirming delivery of the burgers they were owed and that is the end of the transaction. To shield themselves from revealing potential fraud, the brokerage will charge a $500 fee if either of them ask for proof of their burger.

Now, while there may only be one burger in existence, it appears as though there are two, keeping demand artificially flat.

What you’re forgetting is you still have to deliver. If you created burgers out of thin air and sold them (you’re actually creating a promise of a burger, not a real burger) then you’d have to deliver these burgers when whoever bought them calls for them. Or you’d go to jail.

So how could you do this? Well you could create a burger delivery service that sells other peoples burgers. But you sell them for a bit more than what you pay for them and you can begin you’re offering “all the burgers” and connecting the sellers with the buyers. Now you’re creating burgers out of thin air to people buying them from you and you’re delivering the burger they ordered even though you don’t even own a grill. Congrats, you just created a burger exchange that sells promises of future burgers on margin out of thin air.

If you’re even smarter you’d use other people’s money (which is key) to capitalize this venture instead of your own and keep an outsized share of the profits. This is what investment banks and hedge funds do. Other people’s money is key to winning and not really losing.

Your explanation makes a lot of sense. Nonetheless it's bit of a hard sell as it seems to parallel fractional reserve banking to a degree, and we've come to accept the later as the best currently available compromise.

I think the dilution from fractional reserve banking is priced into the buying power of each dollar somehow.

You never look at the value of a dollar as the % of total dollars in circulation. The value of a dollar is rather defined by how many goods/services/other currencies you can get in exchange for it.

With stock it matters a lot more how many % of a company is represented by a single share.

Each loan is also a deposit. Each debit is also a credit.

Similar, each short seller not only adds a _virtual_ share to the market, but also has an obligation to later on buy a share back.

> each short seller not only adds a _virtual_ share to the market, but also has an obligation to later on buy a share back

Again, to be super clear: for everyone but market makers, the law is you have to locate the borrowed share before selling short. Market makers can naked short to provide liquidity in a buying frenzy. Given they're shorting into a buying frenzy, they tend to be quite motivated to immediately cover themselves.

We have lots of people shorting GameStop. We have zero evidence anyone is improperly naked shorting.

And to be fair, they also definitely have to cover themselves before they need to make delivery two days later.

I think naked shorting would be a perfectly valid thing to allow every investor to do, you clearing house would just want to ask for pretty high margin requirements.

Very similar to how there are covered call options, but also naked call options. And the economy hasn't collapsed either.

"Fractional banking" is not a philosophy that can equally apply to cash and stocks, or oil, or sheep. These are different things.

> something is horrifically wrong

Horrifically wrong! Heavens to Betsy!

What went horrifically wrong is the company went public with a clueless CFO. For all corporate actions—reporting, dividends and buybacks—that additional float is meaningless. It’s only relevant for short-term holders and short-term metrics.

With normal shorting the number of shares being traded is no greater than the float. Only with naked shorting can there be more shares traded than float, as in the parent's example. Interestingly, in both cases the short interest can be greater than 100%.

My understanding is that naked shorting can be used to artificially lower the stock price by increasing the supply with the ultimate goal of driving the company into bankruptcy.

So on one side you have illegal(?) market manipulation benefiting sophisticated traders and on the other you have companies that are presumably creating jobs and generating something of value being destroyed as a result of financial engineering.

You can decide if that's upsetting or not.

Both naked shorting and regular shorting reduce the price of the stock. In the case of regular shorting, there is a sale offer that wouldn't have been and was, and in the case of naked shorting, there is a buy offer that would have been and wasn't.

True, but in the case of naked shorting there is now (for some period of time) another share being traded in addition to the shares issued by the company. In the case of regular shorting the float remains the same.

> With normal shorting the number of shares being traded is no greater than the float. Only with naked shorting can there be more shares traded than float, as in the parent's example. Interestingly, in both cases the short interest can be greater than 100%.

Why?

A owns a share, loans it to short seller B. B sells the loaned share back to A. Then A loans the share again to B, B sells it back to A. Now repeat the process a million times.

You can get arbitrarily high amounts of shorting without any naked shorts. (And usually, A and B don't know each other. It's all done via exchanges and clearing houses etc.)

I somewhat follow, but it seems shares have privileges that cannot be synthesized in the same way that dividends and value can. For example, if the firm votes for a new CEO, these shares should have voting power, but B cannot fulfill this obligation to A, so how can these shares be resold to multiple buyers?

When A loans out her shares, she accepts the loss of voting rights as part of the deal. If she cares more about voting her shares than about the income from lending, she will simply direct her broker not to loan out her shares.

In the “A loans to B who sells to C” scenario, C is the one who gets to vote.

> You can get arbitrarily high amounts of shorting without any naked shorts.

That's why I said "Interestingly, in both cases the short interest can be greater than 100%"

But in the situation you're describing the total number of shares on the market is still equal to float.

If we altered your example to have naked shorting it would be: B sells a share it hasn't borrowed to C, A sells a share it hasn't borrowed to D. The total number of shares that can now be traded is equal to the float + 2. Hence the claims of 'counterfeit shares' which is not a great description.

Naked shorting can only be done by market makers. The argument is that it helps to create liquidity and that these actors will have the ability to later borrow the shares without issue. The problem is that, as I understand it, there are not strict rules dictating when they must actually borrow the shares to back the shares that they sold short.

There are some indications that this has happened with GME. For example Michael Burry said in a now deleted tweet[0]:

"May 2020, relatively sane times for $GME, I called in my lent-out GME shares. It took my brokers WEEKS to find my shares. I cannot even imagine the sh*tstorm in settlement now. They may have to extend delivery timelines. #pigsgetslaughtered #nakedshorts"

[0] https://web.archive.org/web/20210130030954/https://twitter.c...

> Only with naked shorting can there be more shares traded than float

Why? Imagine there exists one share of GME, owned by Alice. Bob borrows it from Alice and sells it to Charlie. Now both Alice and Charlie own one share, and no naked short sale ever happened, as far as I understand that term.

I don't know if there's a name for it, but while not naked, it's still a dubious situation unless Bob has secured some way to get the share back to Alice when Alice wants it back. Say Charlie has decided to go hold that share forever; how is Alice ever made whole?

In the only-one-share-exists situation, there's no real way out of that. In a situation where more than one share exists, Bob could, say, obtain a call option so that he at least has a plausible way to acquire a share in the future to make Alice whole.

This results in a similar situation to GME where the short interest is > 100%. WSB wants to be Charlie. They want to hold the share that Bob is legally obligated to buy and can't purchase anywhere else. They can then demand whatever price they want for it.

My understanding is that this leads to short interest greater than 100% but not more shares traded than float as there is still just one share.

In your example Alice doesn't own the share at this point, she owns an agreement that says she will be returned a share in the future and is paid interest on it in the meantime.

While in the specific scenario it's similar, in theory the 2nd scenario can be repeated an infinite number of times since it doesn't need to be tied to a "physical" share.

This creates the illusion that there's a LOT of people who believe the stock will go down in price, which can affect market sentiment and actually cause real movement when in reality that wouldn't be possible if every short was in fact backed by a real share (which they're trying to do via rules making Naked Shorts illegal).

The first scenario can be repeated an infinite number of times, too. Just have A sell the share right back to B and do the same thing. Now A has to deliver two shares to B.

There’s no difference. If you’re going to allow B to borrow A’s share and sell it to D, now both A and D own a share. D can lend their share to E, who sells it to F. (D has no idea they bought some special share, because they didn’t.) Now, F to lend to G who can sell to H, etc.

Yeah this is the explanation I've seen people give.

It's kind of weird to distinguish "naked" shorting from this when they're functionally the same.

Right. Same reason people are flipping out when a stock goes from 199.99% floating to 200.01% floating. (They call it “over 100% shorted!!!”)

How are they functionally the same?

Initial conditions: Alice has a share of XYZ

Proper shorting: Alice lends her share to Bob, Bob sells the share to Carol

=> Alice has a share (lent to Bob, who will have to pay her the eventual dividends), Bob owes a share to Alice, Carol has a share (which has full rights including voting and dividend)

Naked shorting: Bob sells an imaginary share to Carol

=> Alice sill has her share (with full rights)

What does Carol have?

In the situation being discussed, where more shares than the available float are shorted, they are functionally the same because both can theoretically create infinite amounts of shares.

Both look like they "create shares" but the consequences are different. Don't you agree?

Would you rather be the Carol who bought the XYZ stock that Alice lent to Bob or the other one?

Proper-shorting-scenario Carol owns a perfectly good XYZ share.

What does naked-shorting-scenario Carol have?

What do you mean by consequences?

In the naked short scenario you don't immediately have the share, though I'm unsure how important this is for someone shorting the stock.

In saying that, brokers can still fail to deliver the share with non-naked shorting in which case it is effectively a naked short.

In the case of $GME, there were a lot of shares that failed to deliver in December as shown in this /r/wallstreetbets post: https://www.reddit.com/r/wallstreetbets/comments/l97ykd/the_...

I'd say that having the share is important for the person buying the stock.

Short-selling is forbidden to reduce the risk that when you want to buy a share and buy the share you find a few days later that in fact you didn't quite buy a share because whoever sold the share to you didn't have one to sell.

But it's fine, I concede the point.

As far as I care, you can find weird to distinguish "naked" shorting from "borrow-and-sell" shorting because if the short-seller who didn't borrow the stock before selling it does borrow the stock afterwards to be able to settle the trade the end result is the same.

Ok, I understand where you're coming from now.

The person who's most affected by naked shorting is the unsuspecting person who buys the borrowed share from the shorter because nobody actually has that share yet.

From the buyers perspective I can understand the importance of this, I just didn't see how the distinction made a difference to the short interest.

Friction is the difference. Naked shorting removes the need to locate borrow. That need acts to prevent runaway supply expansion. Naked short selling also circumvents the rights of share owners as a class to decide whether to allow synthetic share creation.

Fair enough. I assumed that locating shares to borrow would be relatively easy.

Typically it is, but for heavily shorted stock, the fees go up.

The asset that backs final settlement is different. I can always get cash from some other source to cover scenario 1 (which is also a more straightforward scenario because of that). A share is not some magical, fungible thing that is equivalent to cash; it represents an actual share in a company which comes with actual, legal rights. If a day comes where, as a completely hypothetical example, A is unable to deliver the share they promised to B then there is no externally resolving asset to settle the trade (unless parties agree beforehand to compensate in cash, in which case you get a functional equivalent to scenario 1).

While the mechanics are more-or-less equivalent, the settlement assets in the two scenarios are not which can make a big difference depending on the circumstances of the trade. Neither is generally a problem in a high volume, liquid system though.

That's only half of what's happening, and the objection is directed at the other half.

First scenario, B sells the share they have to X.

Second scenario, B sells the share they don't currently have to X.

And there's a third scenario where B has not even ordered a share, but still sells a share they don't have to X.

The 'naked' in the 'naked shorting' means you haven't borrowed the share before selling it, but you will in the future.

If there are 5 bananas in the entire world and people are still allowed to pretend and sell 500 bananas - you dont see how this is a problem?

Have you actually thought this through?

That is exactly how money and other derivatives works, and it's not, in general, a problem.

If Bob has one of the five bananas but sells Alice a contract for delivery of 500 bananas and then can't make good on his promise, then Bob has screwed only himself, because now people know that Bob's bananas are only worth 0.002 of other people's bananas. Even if Bob finds another rare banana he won't be able to sell it for anywhere near it's true value.

Critically, Bob has only devalued his own banana contracts.

In the meantime, Alice has only the one banana she bought from Bob, and she spent all her savings on that banana, thinking she'd get 500 of them.

But Alice is clever. She has a plan for making back her savings. Alice sells 10 bananas for future delivery to Cecil. Alice plants the one banana she bought from Bob. And sure enough, come delivery time, Alice picks the bananas from her tree and delivers them to Cecil. Cecil, in turn, sold 20 fruit salads for future delivery to other people -- that's how she afforded the banana contract from Alice.

Two observations I want you to make:

1. The one bad actor screwed himself out of the market in no time at all.

2. The 22 good actors managed to allocate capital effectively where it would do the most good for everyone, and allowed entrepreneurs of very little means to start profitable businesses.

Derivatives trading is very resource efficient and has made modern society possible. It has a few drawbacks but they are self-correcting.

There are problems, but they are not with derivatives trading.

Edit: And keep in mind that Bob's banana contracts are not worth anything compared to other people's bananas, but they are still not completely worthless. If Dave owes Erica 50 of Bob's banana contracts, Dave will find it easy to repay them: you can trade almost anything for a Bob banana contract.

You can absolutely sell 5 bananas 500 times.

You can't have 500 net buys (i.e. someone is 'long 500 bananas', or 500 people 'long' 1, etc.), but sales, fine!

>You can absolutely sell 5 bananas 500 times.

But that is not the point. The point is you had 5 bananas to sell and 500 people who bought 1 banana each. Now all 500 monkeys wants its dinner so please deliver. If you can't it is fraud.

The mental gymnastics in the stock market are insane. More shares have been sold than exists. That has nothing to do with the amount of times they were sold.

If it's the same banana, that's fine.

If it's supposed to be a different banana, that's the 'net buys' scenario I described and is not fine, that would indicate naked (which is illegal other than by MMs) short banana selling.

> If there are 5 bananas in the entire world and people are still allowed to pretend and sell 500 bananas - you dont see how this is a problem?

That only becomes a problem if at settlement time there are not 500 bananas. Since you can plant them that's not much of an issue.

When A borrows a share, they sell it to D. Now as far as anyone knows, both A and D own a share but in fact only one exists. The extra sale from A to D also influences the stock price. What some consider bets are creating actual volume on the exchange, along with temporary dilution of shates.

Either way the stock price is influenced. In the first case, supply of the share is increased by the fact that A sells B's share, and in the second case, demand is decreased by the fact that instead of buying a share B buys a contract to have A deliver a share at a later time. Why is this a problem?

What do you mean by "temporary dilution of shares"?

All the shareholders will get dividends, for example. The same as if there were no shorts. The only thing that those who lend their shares will lose is the voting rights - and those who don't lend their shares will vote normally.

That doesn't make sense. If I have to pay each share 5$, and I have given out 500 shares, but when it's time to pay out dividends 700 shares show up to claim them,then someone has to lose money right? Either I have to give 5$ to 200 shares that I never sold to people to begin with, or the 500 people who actually bought shares from me lose some of their portion to the extra 200. What am I missing if that's not the case? Surely that dividend money for those extra 200 shares has to come from somewhere?

Comes from the short-sellers. If I lend a share to you, you owe me a share and all the dividends that I would be receiving.

Alright, thank you. That makes sense.

The naked shorting reduces the value of real shares. Basically because the naked shorters can sell as many nonexistent shares as they want, while the investors who buy can only buy shares that exist.

How does naked (or any) shorting reduce the value of real shares?

Shares are worth the present value of their future dividend cash flow. Shorting doesn't change no dividend payment at all ever.

The money goes to whoever holds the real share.

A loans a share to B. Now A owns an iou, which doesn't have any voting rights. B agrees to pay A an amount of money equal to a dividend payment if a dividend is paid by the company.

B goes short by selling the share to C.

C owns a share of stock.

When the company pays dividends, C is paid and B pays A.

Alright, thank you. That makes sense. How do the voting rights work for share A? I was under the impression that brokerages loaned the shares out without the explicit knowledge of the original owners that it was happening. Is it just that people with margin accounts functionally don't get a vote?

You lose the voting rights as well. Users on brokerages typically agree to this when signing up. Some have opt outs but you may lose features being subsidized by the brokerage having the ability to lend shares.

Cool, thanks for explaining it to me.

The second activity is dangerous because A can fail to deliver. I agree there's not much to be outraged by the first activity.

When I take a loan I may also fail to deliver loan payments. I don't think we should make risk illegal, but we should make sure that banks manage tail risks right.

That's what margin requirements and clearing houses are for.

Even during the heights of the last few financial crises, clearinghouses did not fail.

(Option writers and people trading futures are in a very similar situation to short sellers. They also have clearing houses.)

A can fail to deliver in the first activity, too. More generally, when you agree to have someone give you something of value at a later time, you take on some risk that they will fail to do so.

There's a very different risk profile for me (an individual investor) if I'm buying shares from someone who doesn't have them, and merely promises to deliver them, than if they're backed by real shares. I'd like my brokerage to be holding real shares on my behalf for real dollars I gave them. I don't want them loaning my shares out either.

They're mine.

If there are naked shorts floating around (or shorts covered by my stock without permission), someone else is making money off of risk I am taking on, but didn't agree to. There can be a cascading set of failures which lands with me not having my shares.

It's the difference between taking out a $300,000 mortgage on a $500,000 house, versus borrowing $300,000 with no collateral. You'll get a different interest rate, if you can get a loan at all. And this resembles someone taking a $300,000 mortgage, only missing the house.

Yes, there's always a risk, but that risk profile is very, very different (esp. in the case of catastrophic events, like a stock market collapse or similar, when many institutions might be going down at the same time).

> I don't want them loaning my shares out either.

If you don't want that, don't. It's in your control.

> Nothing they are describing, if you ignore histrionic language like "counterfeiting", seems especially nefarious.

It sure does to me though:

First of all, there's the whole self-fulfilling prophecy thing. On a technical level, everything borrowed is eventually given back, so the effects should cancel out in the end.

The problem starts when the borrowing and selling of stocks happens at a scale where it influences the stock price. At that point, you're a) actively hurting the company b) expecting to profit from it c) sometimes without even expecting the stock price to fall if it weren't for your intervention.

Like, I don't see how financially hurting others for personal gain is not a bad thing, but what makes it even worse is that these might be companies producing actual goods, driving humanity forward, and this is being hindered by economic parasites that are only throwing sticks in peoples way.

It's easy to understand why many believe this should definitely be illegal, and why people without much knowledge of stock markets would expect it to actually be illegal in the first place.

This is the equivalent to shouting "fire" in a crowded theatre... intending to loot whatever people leave behind.

in the second scenario, A would trade a share he doesn’t posses and B could trade the same share, no?

Are you concerned that B could sell his contractual right to have A deliver a share to someone else, so that when A is obliged to deliver a share that actually gets delivered to a third party? Why is that bad?

>> I don't understand why I'm supposed to be outraged by either

You shouldn't. When the economy collapses because of the aforementioned practices and you family loses their jobs, housing etc, you should not be upset either.

Why would the economy collapse?

If anything, it's very good to have short sellers, because they are the only market participants who have an incentive to expose bubbles. And expose them early.

Who knows?

https://www.history.com/news/2008-financial-crisis-causes

The Fed let nominal GDP (and nominal GDP expectations) tank. The rest followed from there.

Farther down it's stated that, as an outcome of this tactic ...

"At any given point in time more than 100 emerging companies are under attack as described above.... The success rate for short attacks is over ninety percent—a success being defined as putting the company into bankruptcy or driving the stock price to pennies. It is estimated that 1000 small companies have been put out of business by the shorts. Admittedly, not every small company deserves to succeed, but they do deserve a level playing field...."

See that's what I don't follow. For most companies, when they IPO, they have the cash on hand from going public. The stock price doesn't really matter anymore for day to day running of the company. Sure a lower stock price long term means that they need to up RSU compensation or won't be able to raise money again, but do those really kill a company?

I IPO for 20 million, giving me 18 months of runway. My stock instantly gets shorted a ton, then what? How does that impact me? How does that put someone out of business? If someone thinks that a company is profitable, they can always invest AND that investment is cheaper because of the 'excess' selling of the shorts.

I don't follow how shorts kill companies.

Ever heard of “The great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”?

New variant: https://prospect.org/power/wall-street-gambling-from-inside-...

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