By Annalyn Censky, staff reporterMay 19, 2010: 2:09 PM ET
NEW YORK (CNNMoney.com) -- "Naked short selling" is the buzz on Wall Street, since a German ban on it sent the stock market tumbling Tuesday. But no, it's not something kinky.
The term "short sale" refers to a type of bet investors can make in the financial markets when they believe a stock or bond will fall. It becomes "naked" when the seller makes the bet without having the goods to back it up.
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"Essentially, you're selling something you don't own," explains David Musto, a professor of finance at the University of Pennsylvania's Wharton School. It sounds impossible, he said, but here's how it works:
When a traditional short seller thinks, say, a bond is in trouble he will set out to borrow the bond, sell it to a buyer at its current market value, and then buy it back after its price falls. He can then pocket the difference and return the security to the bond's original holder, who he borrowed it from in the first place.
But in a "naked" short sale, the short seller makes the deal without ever having access to the securities to begin with. Perhaps he doesn't know anyone he can borrow it from, Musto said. Or he originally had access to a lender, but then some event in the marketplace altered his ability to borrow and deliver the goods.
Until the short-seller has bonds to deliver, the buyer doesn't have to pay. But by showing that a sale has taken place even though the goods haven't actually been transferred, a naked short-sale artificially drives a stock's price down to a level that's not reflective of true supply and demand, said Sharyn O'Halloran, professor of political economy at Columbia University.
Germany banned these so-called naked shorts on government debt and large financial firms late Tuesday, as a way to stabilize what has been a very rocky bond market for Europe, as countries in the region try to finance their debt.
The ruling prohibits investors there from short-selling without proof that they access to the underlying bonds to back it up. By doing so, essentially the ban limits short sales to investors who have access to large brokers or big reserves, O'Halloran said.
The whole purpose is to make their financial markets more transparent and for prices to better reflect true supply and demand, she said.
Throughout history, regulators have cracked down on short selling after a period of economic declines. In the U.S., at the the height of the financial crisis in September 2008, the Securities and Exchange Commission temporarily banned investors from short-selling 799 financial companies.
Yet in spite of its stigma, short selling serves a purpose, Musto said.
"It's a standard part of how markets operate. It's how they bring negative information to bear in the markets," Musto said. "When someone starts trying to restrict it, it seems like an act of desperation."