The SEC is worried about the increase in naked shorting (SEC rules do not seem to have reduced the practice to the levels the SEC prefers) and is now listening to panels of economists on what to do about it. Naking shorting occurs when a person sells stock that she does not own and has not borrowed, intending to either cover and deliver (buy the stock before the three day settlement period expires) or to default on delivery. A trader covers if the stock price falls in the three day period and defaults if the stock price rises (in an amount that exceeds the penalties for a default). Managers hate the practice; they believe it puts unfair downward pressure on their stock price and that the practice is, to some extent, self-contained. Naked shorting itself will depress price, allowing those who do it to cover at the lower price making money on the trading practice itself and not on outside market factors. The SEC does not like; the agency has declared it illegal in most contexts (there are some exceptions for market makers.) But some traders do it anyway.
What to do? The SEC has in place a complex pattern of disclosure rules, soon to get more complex, that require firms be put on a "watch list" for high number trade defaults; those who trade stock of watch list firms have tighter trading rules. The rules work only marginally well. The pure market solutions is to allow other traders, who see naked shorts in a stock, to "squeeze" the shorts by buying stock, forcing the shorts to default. But the squeeze seems to be as much an artifical a price move as the naked short (the SEC does not want pure trading plays to move the market price). The economists want naked traders to pay fees for naked trading equal to the fees paid by those who borrow stock to sell it (short stock). The problem with their proposal is its implementation; how does someone collect the fees??? Indeed, when one looks at implementation one sees that the SEC and the economists are overlooking the obvious.
Naked shorting only works is the penalty for default, failure to cover, is small. If penalties are significant, the naked short seller will cover and deliver not only if the stock price falls but also if the price rises and the rise is less than the penalty he must pay on default. This is a very different bet than a pure negative play. [Indeed, it approximates the play on a legal short; the stock borrower can, after all, refuse to return the stock borrowed.] What is the penalty? Too often in today's markets it is close to zero. The counterparty who does not get the stock promised absorbs the loss (losing the price rise gain), complains, and walks. Simple contract principles give the counterparty damages equal to the full price rise (the counterparty can cover immediately, buying the stock and charge the defaulting party the price of the newly purchased cover net of the price of the original sale, if paid). Damages would also include repayment of the trading costs of the second transactions (a second set of commissions, for example) or a liquidated damage amount included in the trading contract (this could be set at the price to cover plus the price of a short, the price to borrow; the economist's solution). If counterparties that routinely do this, it would solve the naked shorting problem. Naked shorting would become extremely risky (much more than it is) and those left who do it may have information we want in the market price.
Why do some many counterparties walk and not collect damages?? This is where the SEC needs to work. I suggest a simple solution. Require counterparties in defaults to cover immediately (buy the stock not delivered on the date of the default) if the stock sale that fails has been previously publicly disclosed on the ticker (or its trade reporting equivalent) ; disable the counterparties walking away from such deals. Jilted counterparts will be more likely to collect damages from the naked shorts (or refuse to deal with them at all) and the increased buying pressure on the stock (to cover) will reduce the effect of the naked shorting on the stock price. Those counterparties that fail to cover lose their broker/dealer license.
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