A Hidden Threat: Naked Short Selling and Its Impact on the US Economy

Naked short selling is one of the most insidious practices in the financial markets today, yet it often operates in the shadows, unnoticed by regulators and the public. At first glance, short selling seems like a standard, regulated part of trading. However, the mechanism behind how shares are borrowed and sold creates opportunities for abuse, particularly when a broker or clearing firm "locates" shares to borrow without actually ensuring their availability.

This loophole can lead to the creation of “naked” short positions, where traders sell more shares than exist in the market, resulting in artificial downward pressure on stock prices. While larger institutions may reap the benefits of this practice, the consequences are deeply damaging for retail investors and small-cap companies, restricting their access to capital and hampering job creation in the U.S. economy.

The heart of the problem lies within the intricate structure of the U.S. broker-dealer markets, which have become increasingly complex and opaque. Although there are over 5,000 registered broker-dealers in the U.S., a small number of large firms dominate the industry. Most smaller firms, which could have supported nascent companies and created jobs, are now squeezed out of the system, forced to rely on larger clearing firms to settle their trades. This shift, exacerbated by regulatory changes over the past decade, has made it more difficult for smaller firms to engage in meaningful due diligence or help smaller companies access capital. In a market that disproportionately benefits the largest players, the economic playing field is not level, and smaller public companies find themselves at the mercy of larger institutions that can exploit the loopholes in short selling.

The Loopholes in the System: How Naked Shorting Operates

At its core, short selling is supposed to involve borrowing shares from a broker before selling them in the market, with the intention of buying them back at a lower price. However, the practice becomes much more damaging when brokers can confirm the availability of shares through verbal agreements, without any actual verification. Clearing firms often confirm stock availability to multiple traders, allowing them to sell the same shares short multiple times. This results in more shares being sold than are actually available, creating a situation known as naked shorting.

Take, for example, the case of DJT stock, which experiences high daily trading volumes. Multiple traders may request to borrow shares from a clearing firm, and the firm might verbally confirm the availability of, say, 100,000 shares. Traders then mark their sales as legitimate short sales, even though the shares haven't been fully borrowed. As a result, the sale creates a naked short position, and the stock price faces downward pressure as if a higher volume of shares is being traded than is actually the case. In high-volume stocks, such as DJT, this practice can result in millions of shares being sold short in a single day, artificially deflating the price and potentially driving away retail investors. The direct effect of this manipulation is the stifling of capital raises for smaller firms, which depend on stock price stability to raise funds and grow their businesses.

The long-term impact of this practice reaches far beyond individual stocks. As more companies struggle to access capital, the job creation potential in the U.S. is severely limited. Smaller firms, particularly those in their growth stages, are prime targets for naked shorting. These companies often raise capital based on future earnings potential, making them vulnerable to these manipulative practices. Larger institutions, with their far greater access to resources, can short these stocks with little risk, knowing that these smaller firms will likely need to issue more shares to raise capital, further driving down the stock price. This vicious cycle hampers innovation, constrains job creation, and limits the opportunity for smaller companies to thrive in the market.

DTCC and the Incentive Misalignment That Enables Naked Short Selling

The Depository Trust & Clearing Corporation (DTCC) is a critical component of market infrastructure, responsible for clearing and settling trades. However, its profit model—based on transaction volume rather than market integrity—creates a conflict of interest. Like the Federal Reserve is to banks, DTCC serves the major clearing firms that own and control it, making it unlikely to police manipulative practices like naked short selling.

Since DTCC profits from every trade, it has little incentive to verify whether shares being shorted actually exist. Clearing firms routinely “locate” the same shares multiple times, selling more shares short than exist, yet DTCC continues to process these trades without oversight. This results in artificially inflated share supply, suppressed stock prices, and limited access to capital for small companies.

Because DTCC operates with minimal regulatory scrutiny, large institutions benefit while retail investors and small businesses bear the consequences. To curb naked shorting, reforms are needed, including stricter verification of share availability, aligning DTCC’s incentives with market integrity, and enhancing transparency in trade settlement. Without these changes, DTCC will continue enabling market manipulation that stifles economic growth and innovation.

A Path Forward: Reforming the System to Protect Retail Investors and Foster Growth

Addressing the issue of naked shorting requires comprehensive reform to ensure a more equitable playing field for all market participants. Several key steps must be taken to close the loopholes that allow this practice to persist. First, the self-regulatory organization FINRA should be restructured so that all member firms, regardless of size, have an equal stake in decision-making processes. The current ownership structure heavily favors large firms, which allows them to influence regulations to their advantage. By giving smaller firms a more equal voice, we can help ensure that the interests of all participants are considered, leading to a fairer system.

Moreover, the current system of duplicative due diligence should be overhauled. FINRA’s requirement for larger firms to duplicate the work of smaller firms only adds unnecessary complexity and burdens smaller companies. Rather than imposing additional requirements on clearing firms, regulators should allow the due diligence conducted by introducing firms to be sufficient. By reducing this regulatory burden, smaller firms will have the freedom to focus on supporting small-cap companies, which will ultimately benefit the economy by making it easier for these companies to raise capital and create jobs.

The practice of multiple locates, where shares are "located" for borrowing by multiple traders, must also be prohibited. Once a stock is located for borrowing, it should be immediately removed from availability, ensuring that no more shares are sold short than exist in the market. This would help prevent the creation of naked short positions and stabilize the price of stocks, especially those of smaller firms that are more susceptible to manipulation.

Finally, stricter enforcement of short selling regulations is essential. Both the SEC and FINRA need to step up their efforts to monitor and penalize abusive practices in short selling. By implementing more stringent reporting requirements and enhancing market transparency, these agencies can help reduce manipulation and restore investor confidence.

Conclusion: Restoring Capitalism and Encouraging Job Creation

The current system, which disproportionately benefits large institutions, is not only a threat to retail investors but also undermines the potential for job creation and innovation in the U.S. economy. Smaller companies, particularly those in their early stages of growth, are the lifeblood of the economy. They are the ones driving innovation, creating jobs, and contributing to the broader economic landscape. However, when the market is manipulated by practices like naked shorting, these companies are deprived of the opportunity to thrive.

By implementing the reforms outlined above, we can restore fairness to the markets and create a more balanced environment for all participants. These changes will not only protect retail investors but also foster job creation and economic growth. A more transparent and equitable system will enable smaller companies to flourish, driving innovation and helping to create a more diverse and dynamic economy. It is imperative that regulators take swift action to address these issues before the damage to the market, and to American capitalism, becomes irreversible. Through comprehensive reform, we can ensure that the U.S. capital markets fulfill their true potential as a catalyst for economic growth and job creation across the nation.