Germany's Naked Short-Selling Ban:
by: Karl Denninger May 25, 2010
Karl Denninger
The German government is planning to ban the naked short-selling of all German stocks listed on the country’s exchanges in a sweeping enlargement of last week’s contentious bar on the naked short-selling of some securities.
To be clear: Naked short-sales are already illegal.
A bit of explanation is called for here. You can't sell something you don't own. Therefore, to sell short you have to first acquire what you wish to sell. To do this you borrow it from someone else. For example:
"A" owns 100 shares of IBM stock.
"B" wishes to sell short 100 shares of IBM stock.
"B" therefore borrows "A's" stock, replacing that stock with an IOU for the 100 shares, and then sells them to "C."
There are still only 100 shares of stock. "A" is entitled to whatever dividends would normally be paid by those 100 shares even though he doesn't have them any more, and "B" has to make good on that. "C" has the physical shares and gets the cash dividends that are paid on them, if any.
If "A" wishes to sell his 100 shares "B" must return them. He must return them because the IOU "A" has is callable on "A's" demand, irrespective of the price "B" might have to pay to acquire them!
That price might be very high if there are no willing sellers at a "reasonable" price when "B" has to repurchase them. But that doesn't matter - "B" agreed to this when he entered into the short sale. This event, called a "short squeeze," is one of the risks of selling securities short - since you don't own them and have to borrow them the person you borrowed them from might want them back at any point in time - and you're obligated to deliver if that happens, even if it bankrupts you (and sometimes it does).
Unscrupulous people can and have gotten around this problem. How? By not actually having acquired the securities they allegedly sell short.
Hang on a second ... how is that possible?
Today, it's very possible. "Back in the day" it was pretty tough, since stocks were represented as physical pieces of paper. When the trade settled you had to deliver the physical shares.
But today when I place an order to buy a stock my broker says "ok, you did it," takes the (electronic) money out of my account and puts the (electronic) shares in my account. It's all a record in a computer - no physical evidence of those shares pass from one hand to another.
Stocks settle at "T+3," that is, the trade date plus three days. Why? Historically this was because certificates had to be mailed. But today, options and futures settle either same or next day, and stocks don't.
So what happens if I "short" some stock but didn't borrow it first?
Now "A" still has his 100 shares (instead of an IOU) and "C" has his 100 shares. "B" is "short" 100 shares.
Wait a second ... "C's" shares don't really exist in this case.
This is in fact a criminal offense. The specific crime is called "uttering", which is the offense of presenting a counterfeited or forged document to another person with knowledge of its forged nature.
The company who has its bonds or stocks forged and uttered is the harmed party. In addition the party who bought said naked-shorted shares or credit instruments without knowledge of their falsity is also harmed, as they have bought something that is in fact worth nothing as it doesn't really exist.
