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Posted by FrediFizzx on July 20, 2008, 5:23 pm
http://www.rgm.com/articles/investorBD.html
Naked Short Selling Is One Problem A Slumping Market Shouldn't Have
By Christopher Cox
Investor's Business Daily, Inc
July 17, 2008
The demise of IndyMac, coming on the heels of Bear Stearns' desperate
sale to JPMorgan Chase, is a sure sign of the fragility of today's
markets. What's needed now, more than ever, is reliable information
for investors and confidence that trading can be conducted without the
illegal influence of manipulation.
Because financial institutions depend on confidence, they are uniquely
vulnerable in the current climate. A "run on the bank" can take hold
quickly, and can be fatal. But stampedes are not always rational.
When an irrational panic is fueled by a sense of urgency, false rumors
that must be acted on immediately and the fear that everyone else may
get out first, market integrity is threatened. It is the job of market
cops to provide a measure of confidence that financial information
about public companies is accurate and reliable - and when it is not,
to punish those responsible.
Who profits from intentionally false information in the marketplace?
Those who are in on the scam and positioned to benefit from the
predictable response of others who believe the fraudulent information
to be true.
The classic "pump and dump" scheme, in which a stock is inflated
through false information and then dumped on unsuspecting investors
when the perpetrators flee, is one example of how this works. "Distort
and short" is the same thing in reverse.
Naked short selling can turbocharge these "distort and short" schemes.
In a naked short, the usual process of short selling is circumvented,
because the seller doesn't actually borrow the stock and simply fails
to deliver it. For this reason, naked shorting can occur even when
actual shares aren't available in the market. It allows manipulators
to force prices down without regard to supply and demand.
Next week, the SEC will implement an emergency order designed to
prevent naked short selling in the financial firms that the Federal
Reserve Board has designated as eligible for access to its liquidity
facilities.
Because these are large firms with substantial public float, honest
short sellers can readily locate shares to make good on their short
positions. Continued legitimate short selling in these issues will
act, as it is supposed to, as a way for market participants to invest
in the downside and to hedge other positions.
At the same time, eliminating the prospect of naked short selling will
help assure investors that it is safe for them to participate, and
that the current declining market is not the product of unseen
manipulators and "distort and short" artists.
Our emergency order is not a response to unbridled naked short selling
in financial issues - so far, that has not occurred - but rather it is
intended as a preventative step to help restore market confidence at a
time when it is sorely needed.
Many people think naked short selling is already illegal, but that
isn't true. Shares are normally delivered to the buyers within three
days of the trade. But in most stocks, including those covered by our
emergency order, that three-day period can be extended indefinitely.
Even without these extensions, and even when a short seller locates
shares that can be borrowed, there can be problems because the short
seller is not currently required to actually borrow those shares until
settlement.
As a result, securities lenders can tell multiple short sellers they
can borrow the same shares of stock - a sure recipe for a failure to
deliver. Once the commission's order takes effect, this possibility
will no longer exist.
The SEC is committed to maintaining orderly securities markets. The
abusive practice of naked short selling is far different from ordinary
short selling, which is a healthy and necessary part of a free market.
Our agency's rules are highly supportive of short selling, which can
help quickly transmit price signals in response to negative
information or prospects for a company. Short selling helps prevent
"irrational exuberance" and bubbles.
But when someone fails to borrow and deliver the securities needed to
make good on a short position, after failing even to determine that
they can be borrowed, that is not contributing to an orderly market -
it is undermining it. And in the context of a potential "distort and
short" campaign aimed at an otherwise sound financial institution,
this kind of manipulative activity can have drastic consequences.
It was famously - perhaps too famously - said that "markets will
fluctuate." That is certainly true if they are well-functioning. As
market referee, the SEC neither can nor should direct the market's
fluctuations. Instead, our most basic role is to ensure a continued
flow of liquidity to the markets from participants who are confident
the game isn't rigged against them.
Naked short selling can undermine the market's integrity. For the
financial sector in this crisis, certainly, but as soon as possible
for the entire market, this is one worry investors shouldn't have.
Cox is chairman of the Securities and Exchange Commission.
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