On Allowing Naked Positions For Liquidity

Proposal:
    Make it illegal for firms to enter into naked positions on any security. Of particular interest is a firms ability to enter into naked short sale positions for stock.

Brief Analysis:
    I find the SEC's use of the word liquidity in their definition of naked shorts grossly misleading. It is my understanding that liquidity refers to the ease with which an asset can be converted into cash. This definition has led financial advisers to encourage their clients to seek liquid assets as they can come in handy in the event of an emergency. In fact, it is my believe that this word has many positive connotations associated with it, which is why I felt the SEC's justification of allowing naked short sales as a gross abuse of the word.
"Indeed, in certain circumstances, naked short selling contributes to market liquidity. For example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market."

- SEC
     It is clear from the description that naked shorts are permitted to facilitate order executions. Rather than state this, the SEC states the purpose of naked shorts is to improve liquidity. One may argue that there is a strong correlation between order executions and liquidity; however, analyzing the effects of a typical transaction and a transaction involving the sale of a naked short shows this statement is a fallacy.
     In a standard transaction, there are two parties involved, a buyer and a seller. One or both of these parties could be opening a new transaction or closing an existing transaction on their books. If they are closing a transaction, then they are liquidating their assets; if they are opening a transaction, then they are doing the opposite - solidify their position, if you will.
     With a transaction involving a naked short, there is the sale of shares the seller does not posses with the promise to attain the necessary shares in a reasonable time-frame. that is, the seller is selling the shares before they can find someone to borrow them from. In a transaction involving the naked shorting of stock, there is only one party involved in the transaction - the seller. Feel free to read over that again, the transaction involves only one party. If you find yourself questioning the absurdity of even allowing such a transaction, believe me you are not alone, I'll cover the implications of this in more detail in another post.
     The seller of a naked short is always opening a transaction. A naked short sale does not have a buyer, so it is entirely the case that all naked transactions are the result of a new transaction. This is the key point. If all transactions are new transactions, then all transactions lead the involved party to solidify their position - not liquidate it. Hence, allowing naked short selling does not improve liquidity.
     Further, I submit that the allowance of naked short selling reduces market liquidity! Consider what happens when a naked short sales are not allowed. The seller must find a buyer who is willing to purchase the shares, or sit out of the transaction altogether. Hence, there is a chance that the seller will engage in a standard transaction. This means a buyer will be involved in the transaction. Now if this buyer is closing a transaction on their books (that is they initially short sold the same stock), then they are liquidating a position. Viola, an increase in market liquidity.
     Naked positions decrease liquidity. Period.

Prelude To Next Post:
     Lets call it what it is, the SEC is trying to increase the number of orders that get filled. If their short sellers can't find a buyer, the SEC decided to allows them to sell the shares anyway. A similar situation can arise if naked buying is allowed (naked call option purchases for example). In an upcoming post I will discuss why the SEC's goal to maximize order executions is also a bad goal. In fact, I will demonstrate that it is breaking the free market.

Apology:
     I apologize for the lack of posts lately. I have written many drafts but am not fully satisfied with the posts yet. I am trying to improve the readability and quality of my posts. If you notice any errors or find places where I am not as clear as I could be, I encourage you to email me your corrections/suggestions.

Related Links:
    - Division of Market Regulation: Key Points About Regulation SHO -- scroll to Section II. Naked Shorts
    - Bloomberg's Financial Glossary