6 ms·

One thing I don't get about naked short selling: if I bought shares from a short seller and it turns out these shares don't actually exist, what happens to the

One thing I don't get about naked short selling: if I bought shares from a short seller and it turns out these shares don't actually exist, what happens to the money I paid to the short seller? In other words, does the buyer of the phantom shares have no recourse?

alex_h 17y ago
It appears that at least some of the time, the shares are delivered many weeks after the transaction date instead of the required 3 days. This would give the seller of the stock time to wait until the price had fallen before acquiring the stock and giving it to you to settle the transaction. However, I'm not sure how this would work when the number of promised shares far exceeds the actual number that exist. I would love to hear if anyone knows how this works.
- michaelbuckbee 17y ago
  Shorts are really contracts to buy and sell shares at a future time, not actually shares themselves. So, at some future point money has to change hands, not actual shares. Think of it like a bet. If next Friday the share price is over a $100, I'll pay you the difference between whatever the price on the open market is and if it's less than $100 you pay me the difference.
  - brown9-2 17y ago
    I think you are confusing short selling with options.
    - yangyang 17y ago
      Well what he describes isn't how options work either, it's more like futures (assuming his $100 was the futures price for next Friday).
  - barrkel 17y ago
    Shares really do change hands: witness Porsche's market manipulation of hedge funds: http://www.thisismoney.co.uk/markets/article.html?in_article_id=481379&in_page_id=3 http://www.thisismoney.co.uk/markets/article.html?in_article...
hristov 17y ago
I dont know for sure, but there probably is some type of recourse. But the time that would elapse until you start suing people is plenty of time for a short seller to make his money and give you your shares. If the short seller is blown up or cornered, in other words if the price of the shares has climbed so much that the short seller will lose money, then you might be trying to sue somebody who is already in bankruptcy. So that is another problem of shortselling: it affects not only the companies but buyers as well, because buyers may end up holding stock that does not actually exist.
michaelbuckbee 17y ago
The entity victimized here isn't the buyer who is going short it is the company that is "falsely" shorted. An extremely contrived example: Say a company has a 1000 shares of stock out in the market. The broker buys 250 of the shares to sell to the person who wants to short the stock. So if you were looking at this stock from the outside you'd think: "There are 750 shares where people think the price of the stock is going to go up (or why else would they have bought it) and there are 250 shares where people are betting that the price is going to go down (which is how you make money by going short)". Note the 750 shares + 250 shorts = 1000 shares So if someone wanted to short this company on 500 shares, the broker can't find the extra 250 on the open market so they sell the short positions even though they don't have a stock to associate against the last 250 (hence they are "naked"). So you have: 750 shares + 250 actual shorts + 250 naked shorts = 1250 positions in the market on a company that only has issued a 1000 shares. So now you're an investor and you're trying to guess what the future share price of a company will be and you have: Company A with legit shots which you can think of as 750 bets the stock will go up vs 250 bets the stock will go down. and Company B with naked shorts which you can think of as 750 bets the stock will go up vs 500 bets the stock will go down. You'd look at the two of these and go: "Gee, there sure are more people in the world that think Company B's price is going to go down. I'm going to sell my Company B shares before they really tumble and buy up some of that good Company A." So the naked shorts make Company B look less attractive which drives the price down further (making more money for the short positions).
- nsrivast 17y ago
  In this situation, there are more bets/people/indications/information that Company B's price will go down. Yet Company B does not necessarily look less attractive - a high amount of short sales might mean a rise in the price when people cover (buy back) their shorts.
  - michaelbuckbee 17y ago
    The less/more attractive is a matter of interpretation. The core issue is that there are two different sets of rules applying to Company A (no naked short selling) and Company B (naked short selling), but to an outside observer it would appear that there is only one set (no naked short selling as per regulations). This messes up even things like what you are describing: as half the shorts on Company B are naked, there aren't any shares to be bought back, so there would likely be less of a rise than what you would expect.
deleted 17y ago
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abalashov 17y ago
I claim no authority in the matter, but suspect that what happens is that from the buyer's point of view, the shares do exist - superficially. They are represented in some sort of "virtual" format by the seller and backed by some sort of obligation note from the Prime Broker to produce those shares on demand. It's sort of like calling a revolving credit line; if the lender really needs the cash back, they can do it, but most of the time, they don't, and meanwhile, everything you've bought with it is real money for all practical purposes for anyone receiving it. That's just a guess, but logic would suggest I am right. Who in their right mind would buy shares they know are phantom? I think the whole point is that the status of the shares is opaque to the buyer. There are lots of these kinds of transactions in markets; there is some sort of virtual "advance" followed by some sort of belated follow-up/collection effort/call to actually settle the gap. The receiver doesn't know the difference. To some extent, these transactions support efficiency; it's just like if I borrow $1500 from my friend for 3 days to pay the mortgage due today while waiting for money to come in a few days later (an actual situation resembling what I face as a bootstrapped small business owner every month, minus the friend to borrow from!). But when it gets out of hand on this scale, it gets out of hand.
- frig 17y ago
  Can't see why you're being downmodded as you're quite close to the nitty-gritty mechanics. Like most financial systems there's how people think it works and then you look at the actual mechanics and it's quite different; this often leads to semi-informed people thinking they know more than they do. Read here: http://www.law.cornell.edu/ucc/8/ http://www.law.cornell.edu/ucc/8/ ...section 5 (pretty accessible as legal codes go) for the basics. Essentially the laws are structured so that when you buy securities through an intermediary: - "purchasing" shares through an intermediary doesn't instantly give you the shares; it immediately gives you a legal claim against the intermediary to produce those shares - the type of claim you get is very standardized (in terms of delivery times and rules around it, etc.) This makes complete sense if you think about the early years of the stock market. If you went into a brokerage in Chicago in 1940 and bought shares in General Motors, would it really be reasonable to get an actual share certificate instantly? Within an hour? What if it's not Chicago but Poughkeepsie? So the fraud-minimizing solution is that: "purchasing shares" from an intermediary grants you an enforceable claim for those shares that you purchased, but doesn't instantly give you actual shares (it couldn't then, economically). (Needless to say this pushes some of the risk onto intermediaries: since you are buying at whatever price the agent quotes if the stock price were to change then the agent can't ransom "your" shares to you for the post-agreement price change.) A consequence of combining this general setup with the modern electronic infrastructure is that what is essentially fractional-reserve stockbroking becomes possible (if enough brokerages are in on it and if the regulators aren't vigilant enough). The current claims about naked short selling basically reduce to a claim that certain aspects of the order-clearing system are being exploited for fraudulent profit (essentially unregulated fractional-reserve lending, but the specific dynamics are a little different due to the nature of the assets involved). Part of the issue is that if the scam works as the naked-short-selling people think it does then it works best when the naked-shorted company goes out of business within a reasonable time period from when the scam commenced (due to the specific mechanics of how the claimed scam is supposed to work); this makes it hard to accurately assess the merits of many of the claims, since the companies supposedly targeted are usually long-since gone and whenever a company goes out of business there's usually plenty of reasons why it failed that don't involve stock market shenanigans.

alex_h 17y ago

It appears that at least some of the time, the shares are delivered many weeks after the transaction date instead of the required 3 days. This would give the seller of the stock time to wait until the price had fallen before acquiring the stock and giving it to you to settle the transaction. However, I'm not sure how this would work when the number of promised shares far exceeds the actual number that exist. I would love to hear if anyone knows how this works.

michaelbuckbee 17y ago
Shorts are really contracts to buy and sell shares at a future time, not actually shares themselves. So, at some future point money has to change hands, not actual shares. Think of it like a bet. If next Friday the share price is over a $100, I'll pay you the difference between whatever the price on the open market is and if it's less than $100 you pay me the difference.
- brown9-2 17y ago
  I think you are confusing short selling with options.
  - yangyang 17y ago
    Well what he describes isn't how options work either, it's more like futures (assuming his $100 was the futures price for next Friday).
- barrkel 17y ago
  Shares really do change hands: witness Porsche's market manipulation of hedge funds: http://www.thisismoney.co.uk/markets/article.html?in_article_id=481379&in_page_id=3 http://www.thisismoney.co.uk/markets/article.html?in_article...

hristov 17y ago

I dont know for sure, but there probably is some type of recourse. But the time that would elapse until you start suing people is plenty of time for a short seller to make his money and give you your shares. If the short seller is blown up or cornered, in other words if the price of the shares has climbed so much that the short seller will lose money, then you might be trying to sue somebody who is already in bankruptcy. So that is another problem of shortselling: it affects not only the companies but buyers as well, because buyers may end up holding stock that does not actually exist.

michaelbuckbee 17y ago

The entity victimized here isn't the buyer who is going short it is the company that is "falsely" shorted. An extremely contrived example: Say a company has a 1000 shares of stock out in the market. The broker buys 250 of the shares to sell to the person who wants to short the stock. So if you were looking at this stock from the outside you'd think: "There are 750 shares where people think the price of the stock is going to go up (or why else would they have bought it) and there are 250 shares where people are betting that the price is going to go down (which is how you make money by going short)". Note the 750 shares + 250 shorts = 1000 shares So if someone wanted to short this company on 500 shares, the broker can't find the extra 250 on the open market so they sell the short positions even though they don't have a stock to associate against the last 250 (hence they are "naked"). So you have: 750 shares + 250 actual shorts + 250 naked shorts = 1250 positions in the market on a company that only has issued a 1000 shares. So now you're an investor and you're trying to guess what the future share price of a company will be and you have: Company A with legit shots which you can think of as 750 bets the stock will go up vs 250 bets the stock will go down. and Company B with naked shorts which you can think of as 750 bets the stock will go up vs 500 bets the stock will go down. You'd look at the two of these and go: "Gee, there sure are more people in the world that think Company B's price is going to go down. I'm going to sell my Company B shares before they really tumble and buy up some of that good Company A." So the naked shorts make Company B look less attractive which drives the price down further (making more money for the short positions).

nsrivast 17y ago
In this situation, there are more bets/people/indications/information that Company B's price will go down. Yet Company B does not necessarily look less attractive - a high amount of short sales might mean a rise in the price when people cover (buy back) their shorts.
- michaelbuckbee 17y ago
  The less/more attractive is a matter of interpretation. The core issue is that there are two different sets of rules applying to Company A (no naked short selling) and Company B (naked short selling), but to an outside observer it would appear that there is only one set (no naked short selling as per regulations). This messes up even things like what you are describing: as half the shorts on Company B are naked, there aren't any shares to be bought back, so there would likely be less of a rise than what you would expect.

deleted 17y ago

[deleted]

abalashov 17y ago

I claim no authority in the matter, but suspect that what happens is that from the buyer's point of view, the shares do exist - superficially. They are represented in some sort of "virtual" format by the seller and backed by some sort of obligation note from the Prime Broker to produce those shares on demand. It's sort of like calling a revolving credit line; if the lender really needs the cash back, they can do it, but most of the time, they don't, and meanwhile, everything you've bought with it is real money for all practical purposes for anyone receiving it. That's just a guess, but logic would suggest I am right. Who in their right mind would buy shares they know are phantom? I think the whole point is that the status of the shares is opaque to the buyer. There are lots of these kinds of transactions in markets; there is some sort of virtual "advance" followed by some sort of belated follow-up/collection effort/call to actually settle the gap. The receiver doesn't know the difference. To some extent, these transactions support efficiency; it's just like if I borrow $1500 from my friend for 3 days to pay the mortgage due today while waiting for money to come in a few days later (an actual situation resembling what I face as a bootstrapped small business owner every month, minus the friend to borrow from!). But when it gets out of hand on this scale, it gets out of hand.

frig 17y ago
Can't see why you're being downmodded as you're quite close to the nitty-gritty mechanics. Like most financial systems there's how people think it works and then you look at the actual mechanics and it's quite different; this often leads to semi-informed people thinking they know more than they do. Read here: http://www.law.cornell.edu/ucc/8/ http://www.law.cornell.edu/ucc/8/ ...section 5 (pretty accessible as legal codes go) for the basics. Essentially the laws are structured so that when you buy securities through an intermediary: - "purchasing" shares through an intermediary doesn't instantly give you the shares; it immediately gives you a legal claim against the intermediary to produce those shares - the type of claim you get is very standardized (in terms of delivery times and rules around it, etc.) This makes complete sense if you think about the early years of the stock market. If you went into a brokerage in Chicago in 1940 and bought shares in General Motors, would it really be reasonable to get an actual share certificate instantly? Within an hour? What if it's not Chicago but Poughkeepsie? So the fraud-minimizing solution is that: "purchasing shares" from an intermediary grants you an enforceable claim for those shares that you purchased, but doesn't instantly give you actual shares (it couldn't then, economically). (Needless to say this pushes some of the risk onto intermediaries: since you are buying at whatever price the agent quotes if the stock price were to change then the agent can't ransom "your" shares to you for the post-agreement price change.) A consequence of combining this general setup with the modern electronic infrastructure is that what is essentially fractional-reserve stockbroking becomes possible (if enough brokerages are in on it and if the regulators aren't vigilant enough). The current claims about naked short selling basically reduce to a claim that certain aspects of the order-clearing system are being exploited for fraudulent profit (essentially unregulated fractional-reserve lending, but the specific dynamics are a little different due to the nature of the assets involved). Part of the issue is that if the scam works as the naked-short-selling people think it does then it works best when the naked-shorted company goes out of business within a reasonable time period from when the scam commenced (due to the specific mechanics of how the claimed scam is supposed to work); this makes it hard to accurately assess the merits of many of the claims, since the companies supposedly targeted are usually long-since gone and whenever a company goes out of business there's usually plenty of reasons why it failed that don't involve stock market shenanigans.