Is the equity lending involved in naked short-selling structurally equivalent to fractional-reserve banking? Fractional-reserve banking consists in banks lending out more money than they
actually possess. This can also be seen as &quot;money creation&quot;, or at least &quot;money
substitute creation&quot;-- the claim on the bank (e.g. checking account deposit)
is practically equivalent to cash-in-hand.
A short-seller borrows shares in a stock, sells them on the market, buys them
back later, and returns them to the lender. This becomes a &quot;naked short&quot; if the
borrowed shares &quot;do not exist&quot;, i.e. are &quot;share substitutes&quot; credited to a
short-seller's account without being backed by specific shares. Thus
naked-shorting relies on a practice of &quot;fractional-reserve brokerage&quot;.
Fractional-reserve banking is widely accepted while naked-shorting is widely
considered unethical and is in most cases illegal. This confuses me because,
per the above logic, they seem to be the same practice, just with a different
asset class. In both cases, an abstract financial asset in the form of a claim
on a backing asset (bank cash reserves or broker-held equities) is &quot;created
from thin air&quot;. In both cases, the existing stock of the asset in devalued by
the creation of extra units, i.e. inflation.
Am I missing something? Are fractional-reserve banking and fractional-reserve
brokerage, for lack of a better term, &quot;structurally equivalent&quot;? If not, what
are the important differences in their economic effects?
There’s no inconsistency between allowing fractional reserve banking and banning naked short selling. Banks generally lend out money that they borrow (setting aside capital lent), and if one lends out a stock that one has borrowed, that’s not a naked short position, it’s just a plain short. What’s illegal about “naked” shorting (in the U.S.) is selling a stock that one hasn’t either borrowed or determined that one can borrow within the delivery timeframe (currently two days for equities).
The restrictions around money are actually in quite a bit tighter— if a bank were to enter into a transaction that required that it deliver funds and it failed to do so because it couldn’t borrow enough money, it would not be acceptable for the bank to say “oops we thought we could borrow the money sorry” and just pay a small fee (as with equities, where one pays a fails charge). It would instead be an event of default(1), which is more or less the end for a bank.
(1) “Generally, a bank is closed when it is unable to meet its obligations to depositors and others.”