Naked short selling is either one of the greatest threats ever to face the financial markets or not that big a deal.

Naked short selling is a derivation – in most cases an illegal one – of regular short selling. In a normal short sale, the seller borrows stock and then sells it, hoping shares will decline so he or she can buy them back at a lower price.

However, in a naked short sale, the seller doesn’t actually borrow the shares he or she is selling. As a result, the short seller doesn’t deliver the stock to the buyer within a mandated three-day period.

Critics say that can create phantom shares, in some cases making it appear there are more shares being traded than are available. It also can be used as a tool to drive a stock price lower.

“It’s very hard to say conclusively” how widespread naked short selling is, said John Finnerty, a finance professor at Fordham University and principal of Finnerty Economic Consulting in New York. “There certainly is the perception it’s a significant problem.”

In January 2005, the Securities and Exchange Commission began requiring compliance with regulations aimed at addressing the issue. Among other things, Regulation SHO requires stock markets to publish daily lists of stocks in which there are a large number of unsettled trades, called “failures to deliver.”

Although commonly connected with naked short sales, failures to deliver can occur for legitimate reasons and are seen in both long and short sales, according to the SEC.

Regulation SHO also requires brokers to take care of, or close out, failures to deliver in stocks that have appeared on the threshold list for 13 consecutive days.

SEC Chairman Christopher Cox said at a public hearing last week preliminary research indicates the regulation appears to significantly reduce failures to deliver. Since the rule took effect, the average daily number of stocks on the threshold list declined 38 percent, the SEC said.

Cox acknowledged, however, a number of stocks continue to have persistent failures to deliver. To further correct that, the SEC proposed amending Regulation SHO by eliminating a provision that “grandfathered” failures to deliver that occurred prior to the stock being placed on the threshold list.

Critics of naked shorting say the SEC rule has been largely ineffective at stopping the practice. On its Web site, the National Coalition Against Naked Short Selling says: “The systematic violation of the rules against failing to deliver poses an imminent threat to the credibility of the U.S. financial system.”

Others are not nearly as concerned. Owen Lamont, a finance professor at Yale University, called the issue a phantom problem.

“There have been accusations made the entire financial system will crumble. That’s a joke,” Lamont said. “It’s fair to say the naked shorting issue is a massive red herring. The people who object to naked shorting, what they really object to is short selling.”

Not necessarily. Connecticut Securities Director Ralph Lambiase said naked short selling is clearly different than normal short selling. Lambiase, who moderated a panel discussion last year on the topic, said there’s a great incentive to heavily short a stock if the seller doesn’t have to deliver the shares.

He supports tightening the requirements of Regulation SHO. Forcing brokers to borrow shares prior to a short sale – instead of the current mandate that only makes them “locate” shares – would help, he said.

So would creating some sort of substantive penalty for those who don’t “buy in” or take care of unsettled trades in the required 13-day period. Still, Lambiase said the SEC and other regulators have in recent months begun acknowledging naked short selling, and its consequences need to be taken seriously.

“There are some issues, and I think now they’re finally getting some recognition,” he said. “I think there’s a movement afoot to address the problems.”

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