This is fundamentally untrue.
Abusive naked shorting with the goal of driving down prices is illegal. >100% short interest doesn’t require naked shorting at all.
If person A borrows a stock from person B then sells it to person C, they can borrow the stock back from person C and sell it again. No naked short involved.
Re-borrowing the same share does not make it a naked short.
In any case, the important limit here is that financial firms are not supposed to allow hedge funds or other entities to assume short positions for more stock than exists, because if it becomes necessary to execute the trades to resolve the shorts, that extra 40% will fail to deliver, because those shares don't exist.
The SEC actually keeps a list of trading companies with high rates of failure to deliver as a means of detecting naked shorting.
That's only true if you force all shorts to be covered at once without a chain of trades. That's not how it happens.
Person A covers their short by buying a share from Person B and returning to Person C. Person D then buys that share from Person C and returns to Person E to cover their short. That's 2 short shares covered with a single underlying share and no failure to deliver.
Yes, the SEC does track failure to deliver, but >100% short interest does not mean there is naked shorting nor does it imply there will be failure to deliver.
"Naked shorting is the illegal practice of short selling shares that have not been affirmatively determined to exist"
- https://www.investopedia.com/terms/n/nakedshorting.asp
> that extra 40% will fail to deliver, because those shares don't exist
This is not true because all shorts don't have to be covered simultaneously.
> The SEC actually keeps a list of trading companies with high rates of failure to deliver as a means of detecting naked shorting
Funnily enough, $GME had very high failure to deliver rates in December [0] but this is not necessarily due to the short interest.
[0] https://www.reddit.com/r/wallstreetbets/comments/l97ykd/the_...
If you can’t do that then you at least have to get the cooperation of someone who does own the stock in sufficient quantities - and their interests are probably against yours since they, y’know, own the stock.
Banning recursive shorting would be a nightmarish enterprise, since each individual share would need to be tracked to see if it was already shorted. Banning naked shorts supposedly does enough to discourage the behavior. We may be seeing that to not be the case.
Naive question: Why would that ever happen? Wouldn't this scenario just cost person C commissions with no opportunity for gain?
You might be asking instead about the following scenario, though, where a single share is borrowed and sold short multiple times:
Person A borrows from Person C and sells to Person B
Person D borrows from Person B and sells it to Person E
Well, the covering of the shorts doesn't have to happen in an atomic transaction; there are thousands to millions of trades of a single ticker every day. Just as a single share can create a chain of multiple shorts (borrows and sales), a single share can cover multiple shorts too through a chain of trades.
A better analogy to understand why short interest can rise above 100% is fractional reserve lending and the effect that it has on money supply.