The Finance Professor

How Short Selling Works

 

Requirements and Regulations

The borrowing and lending of securities is governed under Federal Reserve Regulation T regulation-t. According to Regulation T, as it pertains to short selling, the short sale must take place in a margin account 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 broker-dealer is able to borrow stock before transacting the short sale. As a result, the Securities and Exchange Commission (SEC 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 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 outstanding-shares.
  • "Naked" short selling is not permissible unless it is for purposes of creating market liquidity liquidity and stability as is the role of market makers market-maker or specialists specialist.

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.

>To order reprints of this article, click here: Reprints

At the time of publication, Rothbort had no positions, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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