Naked short selling is now banned. Why would an institution lend its shares in the first place knowing that its stock portfolio will decline?

Answer

Dear Roderick,

Naked shorting or “uncovered” shorting is shorting (selling) shares without having them in the portfolio and without having borrowed the shares somewhere or having the guarantee that you will be able to borrow the shares. This is prohibited in principle, but it sometimes still happens through detours. Investors (speculators) who short sell uncovered often have no intention of delivering the shares within the regulated period of 3 days. Their aim is simply to make the share price plummet. This is considered malicious market manipulation.

In the “covered” shorting of shares, an investor sells shares that he does not own, but which he does borrow from his broker. When an investor opens a trading account with a broker, he is allowed to short stocks (usually free of charge and unlimited in time), provided he places a certain amount of money in an account as collateral. This is the margin account. So as long as there is enough money in the margin account, the investor has the right to short shares and the broker is obliged to borrow these shares.

In falling stock markets, or during a stock market crash, there are a lot of short sellers in the market. This causes a massive sell-off and stock prices continue to fall sharply. Shortsellers take advantage of this amplifying effect and make big profits, attracting even more shortsellers. This downward spiral of increasingly falling prices could throw the stock market completely off balance, necessitating a ban on short selling.