A lot of financial practices got attacked in the aftermath of the 2008 meltdown and some of the trading techniques employed by hedge funds, banks and other players were harshly pilloried. And one such technique of profiting from a falling price carries the dubious-sounding title of “naked short selling”.

With this practice, the short-seller signs a contract with the buyer which specifies that in some circumstances he might have to make delivery on the contract, and if the buyer elects for delivery, the short-seller must get hold of a stock - or some other security - and hand it over. He does this by buying one from someone else and may incur a loss if the price moves against him. Why should this be thought of as a fraud? Well, according to a recently released film documentary, with the arresting title, “The Wall Street Conspiracy” (Brown Saddle Films and Top On Films), it argues that naked shorting increases the total volume of trading of securities compared to the number that are actually owned in the first place.

In other words, "counterfeit" securities are created out of thin air, the film argues. This increase in the volume of securities can exaggerate a stock move. And if there are failures to deliver – as happens in times of extreme market stress (as when Lehman Brothers collapsed) - some counter-parties end up out of pocket.

The film, which focuses on the stock market rather than other markets like bonds, sets out to argue that naked short selling has destroyed profitable businesses (especially smaller ones) and lined the pockets of Wall Street bankers and their friends but contributes little of lasting value to the broader economy. (The film only briefly mentions non-US markets.) The film claims that many in the media have fallen down on the job of reporting what naked short selling is. The documentary is clearly one-sided – I recall no interview with any major figure defending naked short selling or explaining its legitimacy, contribution to market liquidity, or so on.

Within its limits, the film shows how even a profitable firm can be hit by dramatic, and sometimes unfathomable shifts in prices. A number of business executives, university academics and lawyers who describe naked short selling as a destructive practice are interviewed. And the producers of the documentary give the film an emotional charge – there is a lot of contrasting the heroic “little guy” American businessman versus a slick Wall Street type in his skyscraper (it is always a man). The film very obviously tries to borrow the style and “feel” of Michael Moore's films, for those who are attracted by that sort of thing. The front cover of the DVD I was sent has a picture of people in a yellow Ferrari being showered in dollar bills.

However, I am not entirely sure the production entirely succeeds in accurately describing what is so specifically evil about naked short selling. I do certainly understand the point that short selling makes it possible for more securities to be traded than are in total ownership and subject to claims than are outstanding. But my doubts remain on why this practice is as terrible as the film claims. Consider this argument that I came across on a weblog recently (I don’t have the author’s name):

“I'm struggling with the idea that short selling is immoral and should be illegal. Huge swathes of business activity would dry up overnight. How many factories get built on spec, just in case a manufacturer happens along and chooses to buy the finished product? You sign a contract promising to deliver a factory, or an oil rig, or an aeroplane, and then you go and build it. Tsunamis, strikes, financial difficulties, government action may intervene, preventing you from delivering. You may then get sued. But this mode of business is hardly immoral or illegal. Why should securities be any different?”

Doesn’t that make sense? And consider also that if it is fraudulent to engage in naked short selling, then should it not also, say, be illegal for a bank to loan out far more credit than it has in underlying reserves of bank deposits? It sounds wrong, until you realise that this is current standard practice in modern banking under what is known as the fractional reserve system. If all depositors tried to get their cash in one go, the banking system would collapse. But so long as people understand that a fractional reserve system does not promise all savers they can get all their money out together, then the argument should be: “proceed at your own risk”. With naked short selling, the argument might be the same, that it is perhaps risky, even stupid, but is it really a con?

Anyway, this film deserves to stir up debate, so kudos for the film-makers for taking on what is a difficult subject.