How Short Selling Works

Requirements and Regulations

The borrowing and lending of securities is governed under Federal Reserve Regulation T . According to Regulation T, as it pertains to short selling, the short sale must take place in a margin account (see "Understanding Leverage"). Furthermore, the short sale must be collateralized by the short sale proceeds plus 50% of the short market value, which can be in cash or other marginable securities.

Short sellers cannot execute their orders with reckless abandon. They must obtain confirmation that their broker-dealer is able to borrow stock before transacting the short sale. As a result, the Securities and Exchange Commission (SEC ) enacted Regulation SHO to control short selling and combat abusive practices. The SEC states under Regulation SHO that:

• Short selling is legal except when done to manipulate the price of a stock. Quite often these manipulative practices are referred to as "bear raids."
• Broker-dealers must have reasonable grounds to believe that the security can be borrowed and delivered on the settlement date .
• Broker-dealers are required to "close out" (i.e., buy into) short sales in "threshold securities" that have failed to deliver for 13 consecutive settlement days. Threshold securities are defined as having an aggregate failure to deliver for five consecutive days at a registered clearing agency, composed of 10,000 shares or more and at least half of the total shares outstanding .
• "Naked" short selling is not permissible unless it is for purposes of creating market liquidity and stability as is the role of market makers or specialists .

This installment of The Finance Professor has introduced you to the mechanics and regulations that support the practice of short selling, stock borrowing and securities lending. Next time, I will explain the trading and investment aspect of short selling.