Short Selling, Explained: Locates, Borrow Fees and Failed Trades

Short selling is one of those market activities that sounds like a magic trick the first time you hear it. Someone sells shares they don't own, hoping to buy them back later at a lower price. If the price falls, they pocket the difference. If it rises, the losses can keep climbing.

The trick isn't magic, though. It's borrowing. And the borrowing part is where most of the rules, fees and occasional messiness live.

The basic shape of a short sale

A short sale is the sale of a security the seller does not own, or a sale completed by delivering a security borrowed by — or for the account of — the seller. That definition comes from the SEC's rules and is restated in a range of legal and regulatory write-ups. To settle the trade, the short seller borrows shares, typically from a broker-dealer or an institutional investor, and later returns them after buying equivalent shares in the market.

People short for different reasons. Some are betting on a price decline. Some are providing liquidity when buyers show up faster than sellers. Some are hedging a long position in the same or a related security. The vast majority of short sales are perfectly legal. Abusive ones are not.

There's also a distinction worth keeping straight: naked short selling means selling short without borrowing or arranging to borrow in time to deliver by the settlement date. That is not automatically a violation of federal securities law in every case, but it is where a lot of the trouble starts.

Why "locate" is the word that matters most

In the United States, Regulation SHO is the rulebook. It has four main requirements: marking orders, locating shares, a price restriction that kicks in after sharp declines, and close-out deadlines when delivery fails.

The one people talk about most is the locate requirement. Before accepting a short sale order, a broker-dealer must either borrow the security, enter into a bona fide arrangement to borrow it, or have reasonable grounds to believe it can be borrowed so it can be delivered on the settlement date. The source of that locate has to be documented in writing.

Settlement, by the way, is generally two business days after the trade — "T+2." That's the window in which the seller has to actually produce the shares.

One detail that trips people up: a locate is not the same as a physical pre-borrow. A broker-dealer can rely on reasonable grounds, often confirmed through an "easy to borrow" list less than 24 hours old. And for a short sale that is covered the same day, that same locate can sometimes be reused for a later order — but not in hard-to-borrow or threshold securities. Regulators have flagged that reuse as an area where firms get sloppy.

Locates are documented, but they are not eternal. Think of them as a reservation at a restaurant: it holds your table for a while, not forever.

Covered versus naked — and why regulators dislike surprises

In the European Union, the rulebook is even blunter. Under the Short Selling Regulation, all short sales of shares must be covered, and the same goes for sovereign debt instruments. Naked sovereign credit default swaps are banned outright. The EU regime also layers on transparency: significant net short positions in shares must be reported to authorities at 0.1% of issued share capital and every 0.1% above that, and disclosed to the public from 0.5% and every 0.1% above that. Sovereign debt positions are reported at thresholds ESMA publishes per issuer.

There are carve-outs for market making and authorised primary dealers, and authorities can intervene in exceptional situations — including temporary bans after significant price falls.

The common thread in both the US and EU regimes is settlement risk. When sellers cannot deliver, buyers don't get what they paid for. Repeatedly, regulators frame this as a trust problem, not just a plumbing problem.

Borrow fees: the cost of the ticket

Borrowing isn't free. Short sellers pay a borrow fee, which lenders set based on supply and demand, and which can swing with volatility. Stocks with plenty of lendable supply — think large, liquid names — sit in the "easy-to-borrow" bucket with low fees. Stocks where demand meets or exceeds available inventory are "hard-to-borrow," and the fee climbs accordingly.

These rates are annualized. They're charged every calendar day a settled short position is held — weekends included, because the calendar doesn't take days off even when the market does. And they can move intraday. A position opened when the rate was 1% could, in a squeeze, be facing a triple-digit rate the next morning. That's a real cost that can swamp the original thesis.

Some brokers also pay short credit interest on the cash proceeds from the short sale, which can offset part or all of the borrow fee. Depending on rates and the stock, the net can even be a small credit. The lesson isn't that shorting is cheap — it's that the cost is a live variable, not a fixed entry ticket.

Failure to deliver: common, but usually small

A failure to deliver, or "fail," happens when shares aren't delivered by the settlement date. Fails can come from long sales too — think processing delays, physical certificate transfers, or account allocation errors. They are not automatically evidence of anything sinister.

How common are they? One analysis of SEC data found that roughly 40% of all tickers had shares failing to deliver on an average day in 2020. That sounds alarming until you look at size: failing shares totaled less than 1% of market-wide traded volume on an average day. Almost half of failing tickers were failing on fewer than 1,000 shares, and 79% were for under 10,000 shares.

Fails cluster, though. Companies with very high short interest relative to shares outstanding tend to fail in larger quantities and for more consecutive days. ETFs fail more often than single stocks, likely because building baskets and completing creations takes time.

What happens when a fail persists

This is where close-out rules bite. Under Regulation SHO, clearing agencies and their participants must close out failures to deliver within specified timeframes. Prime brokers typically buy securities in the market to cover a failure, then charge the fund for the resulting losses, including the price impact of buying in a hurry.

The SEC can also pursue enforcement. In one case, the Commission alleged that an adviser and its principal mismarked short sales as long, sold short without locates, and generated more than $2 million in what the SEC called ill-gotten gains. The allegation was that violating the marking and locate rules was more profitable than following them. That case is instructive precisely because the rules it describes are mundane: marking, locating, delivering.

What this means for an ordinary investor

You probably won't run a short book. But if you own shares, you're indirectly connected to this machinery — your broker may lend them out, and you're entitled to understand the risks that come with that.

The rules differ by jurisdiction. The US and EU regimes overlap in spirit but not in detail, and thresholds, exemptions and intervention powers are not identical. If you're curious about a specific market, check that market's regulator. This is general education, not advice, and nothing here says whether short selling is good, bad or right for anyone.

What's clear is that the plumbing is deliberate. Locates, borrow fees, close-out deadlines and disclosure thresholds exist because markets work better when the person on the other side of your trade actually delivers what they sold. Boring, perhaps. But boring is the point.