Short Selling: Background and Policy Issues

Short Selling: Background and Policy Issues

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Updated August 8, 2023
Short Selling: Background and Policy Issues
Short selling generally involves the sale of a stock that the
Benefits and Concerns
seller does not own (and instead borrows and must return at
Benefits of short selling include (1) Pricing efficiency.
a later date) with an intent to profit if the stock declines in
Efficient markets require that securities prices fully reflect
value. The practice has generated policy attention because
available information, including all buying and selling
of its risks and potential association with market
interests. Short selling allows market participants, who
manipulation. This In Focus discusses the mechanics and
believe that a security is overvalued, to express their views
regulation of short selling along with associated policy
in market transactions. These transactions help the markets
issues.
arrive at more efficient prices by allowing market
Short-Selling Operations
participants with negative information about stocks to trade
based on that information even if they do not have pre-
Short selling generally refers to the sale of a security that
existing long positions. In addition, arbitrageurs could use
the seller does not own or does not deliver. A short-selling
short selling to profit based on price discrepancies between
transaction often initiates with the short seller borrowing a
positions that generate similar economic exposures, such as
security from a broker-dealer or an institutional investor
between securities and certain derivatives instruments (that
and selling the borrowed security in the open market. The
derive value from underlying securities). (2) Market
short seller then purchases the security at a later time in
liquidity. Liquidity refers to how quickly and easily
order to return it (Figure 1). A short sale becomes
transactions can occur without affecting a security’s price.
“covered” once the short seller purchases the security to
A high level of liquidity indicates market health and
return to the lender.
efficiency. Short-selling operations contribute to market
Figure 1. Example of How Short Sellers Make Money
liquidity by supplying securities available for trading and
potentially offsetting imbalances between supply and
demand. (3) Market discipline. Some academic research
has found negative correlation between the threat of short
selling and earnings management (the use of accounting
techniques to manipulate a company’s earnings). Short
selling may thus have the effect of disciplining corporate
management.
Short selling has also generated criticism. Some contend
that short selling is often a form of market manipulation.
Some short sellers may, for example, spread false rumors to
drive down share prices or collude with one another to
move prices lower (a strategy that is often called a “bear
raid”). Abusive short-selling activities, such as coordinated
transactions to depress the price of a security for a short
sale gain, are illegal. In 2008, during the Great Recession,
the United States and other countries imposed bans on
certain short-selling activities, hoping to mitigate share
price declines and reduce market volatility. Section 12(k) of
the Securities Exchange Act of 1934 gives the Securities

and Exchange Commission (SEC) the authority to
Source: CRS.
temporarily prohibit short selling in certain emergencies.
If the price of the security decreases (as expected by the
“Naked” Shorts
short seller), the short seller profits by returning the security
A “naked” short is a short sale conducted without
after purchasing it at a lower price than it was sold. The
borrowing or arranging to borrow the relevant shares (but
short seller loses money if the share price increases. From
agreeing to deliver them at a later date). Naked shorting
this perspective, short selling is potentially riskier than
may result in a failure to deliver the shares to the buyer. For
long-only investing. The maximum loss for a long investor
example, the short seller, who trades illiquid shares, may
is 100% of a stock’s value. In contrast, short sellers face
have trouble buying the securities when the time for
unlimited losses because, in theory, there is no limit to a
delivery comes up. Some naked shorts are in violation of
stock’s potential price appreciation and so no limit on the
securities laws. But not all naked shorts are illegal. For
price at which short sellers may be obliged to purchase
example, certain market maker activities that involve
shorted stock to deliver to a lender.
broker-dealers making a market by committing to
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Short Selling: Background and Policy Issues
continually buy and sell securities even without other
Congress held several hearings and considered multiple
buyers or sellers (i.e., “bona fide market making”) generally
legislative proposals associated with GameStop-related
do not violate securities regulation.
developments in 2021. For example, the Short Sale
Transparency and Market Fairness Act (H.R. 4618 in the
Regulatory Frameworks
117th Congress) proposed reducing the reporting time
SEC Regulation SHO (Reg SHO), pursuant to the
window and expanding reporting content for certain short
Securities Exchange Act of 1934 (P.L. 73-291), establishes
positions. It would have also required the SEC to
the framework for short-selling regulation. Reg SHO’s key
promulgate rules that would mandate public disclosure of
provisions include
certain short-selling activities by asset managers.
Rule 201, also called the alternative uptick rule, is triggered
The SEC published a staff examination of the situation
when a stock’s share price falls at least 10% during intraday
titled Staff Report on Equity and Options Market Structure
trading. If that occurs, short selling in the stock is allowed
Conditions in Early 2021. Among other things, the report
for the remainder of the day and the following trading day
found that short selling was a significant part of the
only if the price of the stock is above the current National
GameStop story. However, a short squeeze was not seen to
Best Bid and Offer (the best prevailing offers to buy or sell
have been a main driver of the GameStop stock behavior in
shares for a stock on stock exchanges). This places
January 2021. The report identified several areas for further
restrictions on short selling when a stock faces significant
regulatory consideration, including improving the reporting
downward price pressure, potentially stabilizing market
of short sales. While the report acknowledged that some
conditions during episodes of distress.
had raised concerns about naked short selling, it indicated
that members of the National Securities Clearing
Rules 203(b)(1) and (2) establish what is known as the
“
Corporation did not experience persistent failures to deliver
locate requirement” for short sales. Subject to certain
GameStop stock during the relevant period—a fact against
exceptions, these regulations prohibit a broker-dealer from
the theory that naked shorting played a major role in the
accepting a short-sale order unless it has borrowed the
GameStop episode.
relevant security, has entered into a bona fide arrangement
to borrow the security, or has reasonable grounds to believe
SEC Short Selling Disclosure Proposals
that the security can be borrowed so that it can be delivered
Section 929X of the Dodd-Frank Wall Street Reform and
by the delivery due date. The rules also require
Consumer Protection Act of 2010 (P.L. 111-203) requires
documentation of compliance with these requirements.
the SEC to prescribe rules to make more short-selling data
These rules are intended to curtail naked shorting outside of
publicly available. On February 25, 2022, the SEC
certain recognized exceptions.
commissioners unanimously approved proposed rules
Rule 204 establishes the “close-out requirement,” requiring
aimed at fulfilling Section 929X’s mandate. The proposed
a firm that clears and settles trades to deliver securities to a
rules would add a new rule, Rule 13f-2, and a new
registered clearing agency for clearance and settlement on a
disclosure form, Proposed Form SHO, under the Securities
long or short sale in any security by the settlement date.
and Exchange Act (P.L. 73-291). As proposed, Rule 13f-2
Alternatively, the firm must take actions to close out
would require institutional asset managers, who exercise
failures to deliver by borrowing or purchasing similar
investment discretion over short-selling positions and meet
securities within a certain time. This requirement is
specific thresholds, to report information on the Proposed
intended to curtail failures to deliver due to abusive naked
Form SHO. The new reporting includes the asset managers’
shorting.
end-of-the-month short positions and certain daily activities
affecting those short positions. The SEC would then
Case Study: GameStop in 2021
aggregate the resulting data by individual security and
Short selling has drawn policy attention during periods of
disseminate the data publicly on a monthly basis. This new
abnormal trading. For example, a market frenzy occurred in
data would supplement the short-sale data that is currently
early 2021 when the stock price of video game store chain
publicly available from Financial Industry Regulatory
GameStop rapidly increased from around $18 to well over
Authority and national stock exchanges.
$400 in intraday trading. The developments soon spread to
The SEC also proposed several other provisions to amend
some other stocks and markets. The episode raised several
Reg SHO and the Consolidated Audit Trail, a trading order
policy issues, including the role of short selling in equity
data tracking system. These amendments would require
markets. At the time, many traders reportedly targeted
GameStop’
broker-dealers to collect and submit additional data on
s stock because it was heavily shorted. Some
purchases to cover short sales, among other requirements.
speculated that retail traders sought to engineer a “short
The new data would provide more transparency on market
squeeze”—a phenomenon whereby an increase in a stock’s
activity related to short selling and help regulators to
price prompts short sellers to buy the stock to cover their
reconstruct market events and identify potential abusive
positions, leading to a spiral of further price increases and
trading practices.
further short covering. Hedge funds that had shorted
GameStop shares reportedly incurred losses of around $20
billion as of the end of January 2021. Because at one time,
Eva Su, Specialist in Financial Economics
140% of GameStop’s outstanding stock had been shorted,
IF12400
some have raised concerns that the episode involved naked
shorting that warrants regulatory review. Others deny that
high short interest necessarily indicates naked shorting.
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Short Selling: Background and Policy Issues

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https://crsreports.congress.gov | IF12400 · VERSION 3 · UPDATED