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If you think that the value of a stock will rise, you can buy the stock and sell it later when the price is higher. If you think that the value of a stock will fall, the situation is a bit more complicated. One way to bet on a falling stock price is to sell short, that is to sell stock that you do not own, with the idea of buying it back when the price is lower. But selling something that you do not have creates a potential risk to the buyer, who receives a promise instead of the thing he wanted to buy. Clarification: I am not a lawyer and nothing in this article is intended to constitute legal advice; I am an economist attempting to analyze what happens in securities markets.
If you buy a stock from someone, the seller of the stock gets paid at settlement (a few days after the transaction is done). You pay cash and receive the shares of stock and there is no further risk to either party. But if you sell stock that you do not own the settlement transaction is problematic. You receive the cash but the buyer of the stock only receives a promise to receive shares from you in the future. If you have excellent credit this should not present much of a problem. The buyer of the stock will want occasional payments (the short seller must pay the buyer all dividends paid by the corporation) but otherwise should be satisfied having your promise to eventually deliver the stock. There would be an arrangement between the short seller and his stock broker, where the broker would guarantee the eventual delivery of the stock by requiring a substantial deposit from the short-seller.
But US regulators impose an additional complication, that the brokerage firm lend the shares to the short-seller, typically from the account of another investor at the same brokerage firm (see here for the SEC’s 2005 explanation of Regulation SHO governing short sales). The short seller must pay the brokerage firm interest for the loan of the shares, in addition to covering the dividend payments noted above. Under the SEC rule the brokerage firm delivers the shares at the time of settlement to the buyer; the only open transaction is typically inside the brokerage firm, between the seller of the shares and the account that lent the shares.
Even so, there are occasional “naked” short sales, where the seller does not deliver the stock at the time of settlement (”failure to deliver” in the language of the SEC). The SEC slyly notes that “[n]aked short selling is not necessarily a violation of the federal securities laws or the Commission’s rules”, a statement guaranteed to cause brokerage firms to regularly consult their legal staff. The SEC set up a list of “threshold securities”, that is companies that regularly experience delivery failures to ensure that there are no further problems with these shares (see here for the NYSE list of threshold securities and here for the NASDAQ list). Presumably brokerage firms are more careful when their customers try to sell short firms already on these lists.
The SEC’s stated purpose is to prevent abusive short sale practices, something that SEC Chairman Cox has termed “short and distort” (see here for a law firm’s discussion). This practice is the negative version of “pump and dump” (see here); the “pump and dump” scenario is an unscrupulous promoter will buy a large position in a small company and then spread rumors to try to drive the price of the stock up (my spam folder was full of these messages a few years ago; see here in the section E-mail spam), selling the shares once the price rose a bit. “Short and distort” would involve taking a large short position in a company and then spreading rumors to drive down the share price.
On July 15, 2008, the SEC released an emergency order (see pdf here or a subsequent explanation here) that more or less says that no naked short selling would be permitted for a number of large banks and investment banks (the so-called primary dealers, see here) and Fannie Mae and Freddie Mac.