For the regular definition, this link should suffice. In this post, I discuss the cycle of a short sell trade and obligation of an exchange participant whilst executing short-sell trades.
Cycle of a Short-sell trade
A short trade involves an analyst (hedge fund) predict the decline of a security (could be for various reasons). Based on this study an investor (Hedge Fund) decides to “short-sell” the security.
Short-sell involves the investor borrow security from a lender (Prime Broker) at a borrowing/lending cost, sell the security and when the price of the security depreciates buy and return the security .
The difference between the 2 transactions minus the borrowing cost is the profit for an investor.
A Pictorial representation
Obligations of an agency broker
An agency broker does not take risk on its own books, it executes trades based on instructions received from the client .An agency broker must ensure all short sell trades are flagged and reported to the exchange .
If a Broker suspects that a client is selling short and have not flagged the trade as short, the Broker must confirm with the client.
Risk of naked short sells for day trading clients
A naked short sell is a short sell for which no buy exists i.e trying to sell a security that you have not borrowed (covered)
Naked short sell is a severe breach of compliance and heavily penalized. Given day trading clients usually HFT (high frequency trading) execute thousands of buy and sell orders for the same security in a given day, there is always a risk of over-selling i.e selling more than what was bought for a given security in any given trading day.
HFT clients put adequate checks within their OMS systems before routing an order to the broker for execution. Brokers additionally could have checks built within their system as well.
In the event of a system glitch the naked short sell is reported to the exchange by end of trading day (within a certain cut-off time) and the reason for non- compliance explained with adequate assurances of compliance in the future.