Tuesday, July 29, 2008

Independent on Shorting.

The Big Question: What is short selling, and is it a practice that should be stamped out? From the Independent. Found by Zbuxster of Yahoo.

"If all goes according to plan, the investor is paying less to buy back the shares than it received for selling them. There are some costs involved, notably that the lender charges a fee for loaning out its shares, but in an ideal world the shorter still makes a tidy profit.

There's a variation on this theme, known as "naked short selling" – a form of shorting where the investor doesn't even bother to borrow the shares it is betting against. This is possible because share deals are often not settled immediately. The seller promises to deliver the stock after a short delay – say three days. If a short seller buys the stock back before it has to make good on the original delivery, no shares need actually change hands."

Here's something that I haven't really seen discussed.

When a short seller borrows shares from someone, they have to pay interest on those shares.

What happens if a Hedgie Naked Shorts? Who do they pay interest to? I think the answer is "nobody." They don't borrow shares, they pay no interest. This means that there is an actual financial incentive to Naked Short as opposed to sell a Covered Short. It's cheaper to Naked Short.

Really, I'd think that logically, even assuming that naked shorting were legal, that the naked shorter should owe interest to the BUYER of that FTD. Really, it could be said that the person that sold the share, but didn't deliver, is actually borrowing a share from the BUYER.

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