On July 15th, the Securities and Exchange Commission (SEC) issued an emergency order to enhance investor protections against naked short selling, and specifically listed 19 securities that they will closely monitor, including heavily shorted financial firms such as Fannie Mae, Freddie Mac, Citibank, Lehman Brothers, Bank of America, Merrill Lynch, and others. Technically speaking, nothing has changed and the “emergency order” really served as an “emergency reminder” of the rules against naked short selling. The recent panic in the financial markets needed this emergency reminder to stem the aggressive short selling in these 19 firms that were specifically mentioned, and also served to provide some short term recovery in these securities due to the panic short covering that resulted. But what is short selling and naked short selling, and what is the difference? Read on to discover.

Short selling refers to the selling of a security that the seller does not own. Most stock trades take place by first buying a security and then later selling it a price which is hopefully higher then when you bought it. Short selling takes the opposite approach, and is used when the “short seller” thinks the price of the security will go down. They first SELL the position they do not own, and to complete the transaction, they buy it back, and hopefully at a lower price then they first sold it for.

But the SEC rules say nothing about short selling by itself, and even went so far as to condone the practice of short selling. It is the naked short selling that they are clamping down on, which incidentally was illegal even before the emergency SEC “reminder”. In a regular short sale, the seller does not own the security they are selling, but their brokerage firm may have plenty of shares available to cover them against the SEC naked short sale rules. In fact, brokerage firms regularly monitor their inventory levels of all shares held by all clients, and the total net long position counts of each must remain positive at all times. If a brokerage has a total share count within their house that is negative, then they are violating the naked short sale rules of the SEC.


Based on my conversations with Scottrade brokers, here is how it works. A customer attempts to sell short 100 shares in Fannie Mae. Before completing the transaction, Scottrade checks their internal database to ensure that the net position of all accounts in their house is positive for Fannie Mae. If it is, then the short sale is allowed to go through. If it is not, then Scottrade will not complete the short sell order. But what happens if to many other other Scottrade customers sell their long Fannie Mae positions after I institute my short sale? In that case, the Scottrade net long position for Fannie Mae may go negative, in which case they randomly select an account with a current short position, and then instruct them that they must close (BUY to cover) their short position by the end of the current trading day.

So if Scottrade and others have mechanisms to prevent naked short sales, then who exactly are the naked short sellers that are violating the SEC rules? The SEC did not specifically name the violators, but more then likely we are talking about huge financial and trading institutions breaking the rules en masse.

How does the naked short sale reminder effect the Ultra BEAR ETF’s and Mutual Funds? The Rydex Inverse 2X Financial ETF (RFN) and the Proshares Ultrashort Financials (SKF) are two that come to mind. They both claim to seek investment results that correspond to twice the performance of the inverse of the financial sector. But they each go about it in different ways.

Proshares does not actually short stock to reach its double inverse performance. They utilize something called return swap contracts, which are direct contracts between proshares and some other institution, whereby they agree to guarantee and swap out their respective performance. Looking at the daily holdings of the proshares ultrashort financials, there are only two holdings - “DJUSFN Swaps”, and cash. The naked short sale rule should not affect proshares inverse funds, but those shares may be affected by something else called counterparty risk. Proshares does not disclose who the counterparties are with their return swap contracts, but the is risk that those counterparties may fail to deliver on their end of the contract, leaving the investor holding the (empty) bag. MAS explained the counterparty risk here.

Rydex takes the direct approach with their inverse funds by directly shorting the market at twice the rate. The size of Rydex, and the scale of their net short position in these inverse funds is certainly reason for concern. And if we suddenly see them limiting new investments in their ultra inverse shares and funds, it will likely be related to the SEC’s naked short sale warning.