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1 1 (August 8, 2023)

handle is hein.crs/govemls0001 and id is 1 raw text is: Congressional Research Service Informing the legislative debate since 1914 Updated August 8, 2023 Short Selling: Background and Policy Issues Short selling generally involves the sale of a stock that the seller does not own (and instead borrows and must return at a later date) with an intent to profit if the stock declines in value. The practice has generated policy attention because of its risks and potential association with market manipulation. This In Focus discusses the mechanics and regulation of short selling along with associated policy issues. Short-Selling Operations Short selling generally refers to the sale of a security that the seller does not own or does not deliver. A short-selling transaction often initiates with the short seller borrowing a security from a broker-dealer or an institutional investor and selling the borrowed security in the open market. The short seller then purchases the security at a later time in order to return it (Figure 1). A short sale becomes covered once the short seller purchases the security to return to the lender. Figure I. Example of How Short Sellers Make Money Institutional investors receive the shares back. returns the shares to the broker and books a gain. I, buys the same number of shares back at a lower market price. Institutional investors lend shares. shares from abroker for a fee. Y 4 I-sells the borrowed shares at the current market price. The shares lose value as expected by the short seller. Source: CRS. If the price of the security decreases (as expected by the short seller), the short seller profits by returning the security after purchasing it at a lower price than it was sold. The short seller loses money if the share price increases. From this perspective, short selling is potentially riskier than long-only investing. The maximum loss for a long investor is 100% of a stock's value. In contrast, short sellers face unlimited losses because, in theory, there is no limit to a stock's potential price appreciation and so no limit on the price at which short sellers may be obliged to purchase shorted stock to deliver to a lender. Benefits and Concerns Benefits of short selling include (1) Pricing efficiency. Efficient markets require that securities prices fully reflect available information, including all buying and selling interests. Short selling allows market participants, who believe that a security is overvalued, to express their views in market transactions. These transactions help the markets arrive at more efficient prices by allowing market participants with negative information about stocks to trade based on that information even if they do not have pre- existing long positions. In addition, arbitrageurs could use short selling to profit based on price discrepancies between positions that generate similar economic exposures, such as between securities and certain derivatives instruments (that derive value from underlying securities). (2) Market liquidity. Liquidity refers to how quickly and easily transactions can occur without affecting a security's price. A high level of liquidity indicates market health and efficiency. Short-selling operations contribute to market liquidity by supplying securities available for trading and potentially offsetting imbalances between supply and demand. (3) Market discipline. Some academic research has found negative correlation between the threat of short selling and earnings management (the use of accounting techniques to manipulate a company's earnings). Short selling may thus have the effect of disciplining corporate management. Short selling has also generated criticism. Some contend that short selling is often a form of market manipulation. Some short sellers may, for example, spread false rumors to drive down share prices or collude with one another to move prices lower (a strategy that is often called a bear raid). Abusive short-selling activities, such as coordinated transactions to depress the price of a security for a short sale gain, are illegal. In 2008, during the Great Recession, the United States and other countries imposed bans on certain short-selling activities, hoping to mitigate share price declines and reduce market volatility. Section 12(k) of the Securities Exchange Act of 1934 gives the Securities and Exchange Commission (SEC) the authority to temporarily prohibit short selling in certain emergencies. Naked Shorts A naked short is a short sale conducted without borrowing or arranging to borrow the relevant shares (but agreeing to deliver them at a later date). Naked shorting may result in a failure to deliver the shares to the buyer. For example, the short seller, who trades illiquid shares, may have trouble buying the securities when the time for delivery comes up. Some naked shorts are in violation of securities laws. But not all naked shorts are illegal. For example, certain market maker activities that involve broker-dealers making a market by committing to

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