This is from 2008 but I don't think much has changed...
object.cato.org/sites/cato.org/files/serials/files/regulation/2008/2/v31n1-7.pdfNaked short selling involves selling without first borrowing
stock (or even locating stock to borrow). If a naked short seller
does not borrow the stock he sells, he will be unable to
deliver that stock to the buyer to settle the trade. Intentional
naked short selling is illegal, though market makers are currently
allowed to naked short temporarily when engaged in
bona fide market making. (Even market maker ftds, however,
are illegal when delivery failure exceeds 13 days.)
In U.S. equity markets, settlement occurs within three days
of a trade. In the case of both long and short sales, if shares are
unavailable for delivery then the settlement process can be
complicated by ftds and “failures to receive” (ftrs). To the
extent that ftds and ftrs are only occasional and temporary,
trade in security entitlements rather than physical shares helps
to keep markets liquid and efficient.
Delivery failures are problematic, however, when they are
large and persistent. In those situations, ftds act as “phantom”
or counterfeit shares that circulate in the system as real
shares. Just as counterfeit currency dilutes and destroys value,
phantom or counterfeit shares deflate share prices by flooding
the market with false supply.
LOCATE REQUIREMENT Another crucial loophole in
Regulation sho lies in the nebulous wording of the “locate”
requirement, which allows a broker-dealer to execute a short
sale with only “reasonable grounds to believe that the security
can be borrowed so that it can be delivered.” The locate
requirement originated with sec proposed rule 10b-21 (1973),
which said one “had to borrow or have reasonable grounds to
believe the stock could be borrowed” prior to effecting a short
sale. That rule was withdrawn, but the concept later evolved
into nasd Rule 3370, which requires that “prior to accepting
a short sale order…a member must make an affirmative determination
that the member will receive delivery of the security
from the…broker-dealer or that the member can borrow the
security on behalf of the…broker-dealer for delivery by the settlement
date.” This vague standard makes meaningful enforcement
nearly impossible; the “reasonable grounds” condition is
easy to meet and difficult for a prosecutor to refute.
Regulation sho includes important exceptions to the
locate requirement. Besides the options market maker exception
discussed above, there is an exception for stocks on socalled
“easy-to-borrow” lists. Regulation sho states:
“Easy to Borrow” lists may provide “reasonable
grounds” for a broker-dealer to believe that the security
sold short is available for borrowing without directly
contacting the source of the borrowed securities. In
order for it to be reasonable that a broker-dealer rely
on such lists, the information used to generate the
“Easy to Borrow” list must be less than 24 hours old,
and securities on the list must be readily available such
that it would be unlikely that a failure to deliver would
occur…. [R]epeated failures to deliver in securities
included on an “Easy to Borrow” list would indicate
that the broker-dealer’s reliance on such a list did not
satisfy the “reasonable grounds” standard of Rule 203.
Broker-dealers also create “hard-to-borrow” lists, but “the
fact that a security is not on a hard-to-borrow list cannot satisfy
the ‘reasonable grounds’ test” of Regulation sho.
THE IMPACT OF FTDS
ftds threaten market integrity in at least three ways:
■ They undermine corporate voting mechanisms.
■ They damage and destroy firms.
■ They increase the possibility of systemic collapse.
Below is an interesting recent PR by a pharma company:
www.pharmacytebiotech.com/pharmacyte-biotech-retains-industry-expert-to-monitor-short-sellers-and-market-makers/