Understanding Custody-Only Trading

While conventional short selling involves the sale of borrowed stock, "naked" short selling refers to short sales by traders who have no intention of borrowing and then selling the stock. Rather, they simply resort to short selling without borrowing the stock or ensuring that it can be borrowed, thereby driving down the price of the stock precipitously. Since custody-only trading requires purchase and sales of physical shares only, there is no stock for short-sellers to borrow or pretend to borrow, thereby discouraging naked shorting. In 2008, the SEC banned "abusive" naked short selling in the United States.

For certain types of investors, like a hedge fund or a buy-and-hold investor, they may prefer to hold investment securities that are not subject to the speculative intentions of short-sellers. Custody-only makes sense because it prohibits speculators from driving security prices around erratically with naked short sales.

In reality though, naked shorting is not a major problem on the vast majority of listed stocks. Although, it may be more of a problem for stocks that trade over-the-counter (OTC) or aren't listed on a major exchange. These are typically small companies or penny stocks that are already highly speculative in nature.