Reg SHO Locate Requirement for Short Selling

Before a broker can execute a short sale, it must locate borrowable shares—confirming that securities exist and can be borrowed to deliver on settlement day. This is the Reg SHO Locate Requirement, a critical rule under SEC Regulation SHO designed to prevent naked short selling (selling shares you haven’t borrowed) and reduce fails-to-deliver. The locate obligation applies primarily to broker-dealers, who must document the locate before order execution and monitor fails-to-deliver across their short position inventory.

The Problem: Naked Short Selling and Fails-to-Deliver

Before Reg SHO’s Locate Requirement (adopted 2005), it was theoretically possible for a broker-dealer to execute a short sale without confirming it could borrow shares. The short seller would deliver an IOU on settlement day instead of actual securities. These settlement failures, or fails-to-deliver, created “naked” short positions—borrowed shares that never actually existed.

Fails-to-deliver are problematic because:

• Dilution illusion: Investors buy shares thinking they own them, but the broker never actually borrowed or delivered them. This can artificially inflate float and dilute shareholder value.
• Forced buy-ins: When a fail-to-deliver persists, the broker must buy the shares at market price to settle, potentially causing sudden price spikes that hurt the short seller.
• Market integrity: Uncontrolled fails undermine price discovery and settlement certainty.

The Locate Requirement was designed to prevent this. Before executing a short sale, the broker-dealer must confirm that shares are available to borrow—and document it in writing.

How the Locate Requirement Works

Before Order Entry

The broker-dealer (or its prime broker for a hedge fund executing the short) checks its available inventory of shares to borrow. This check typically happens through:

• Internal borrow desk: The firm’s own stock lending operation notes which shares are available for short sale
• Prime broker borrow availability: For hedge funds, the prime broker confirms it can lend the shares
• Third-party borrow sources: The broker may consult external borrow facilities or market makers who aggregate lendable shares

Once the broker-dealer confirms shares are locatable, it creates a locate ticket—a contemporaneous record showing:

• The security symbol and quantity
• The date and time the locate was confirmed
• The source of borrowable shares
• The identity of the broker-dealer executing the locate

This ticket must be created before the order is entered into the exchange or alternative trading system.

After Execution

The located shares are typically flagged in the broker-dealer borrow system, ensuring they are not double-allocated to multiple short sellers. On settlement (usually T+2 for stocks), the broker-dealer must deliver the securities or replace the failed position via a forced buy-in.

If the broker-dealer cannot deliver on settlement day, it becomes a fail-to-deliver and the broker-dealer is out-of-pocket. It must buy-in the position at the market price, often at a loss. This creates a strong incentive to locate before accepting the order.

Documentation and Record-Keeping

Reg SHO requires broker-dealers to maintain detailed borrow records:

The SEC exam teams regularly request these records to verify compliance. A broker-dealer that cannot produce a locate ticket for a short sale faces examination findings and potential enforcement action.

Close-Out Rules for Fails-to-Deliver

Under Reg SHO Rule 204T (now simplified to Rule 204), a broker-dealer must close out any fail-to-deliver by the end of the settlement date (T+2 for equities). If shares are not delivered by T+3 or T+4 (depending on SEC emergency orders), the broker-dealer must buy-in the position at the market price and force it to the short seller or its lender.

A buy-in order is typically executed at the best available price, sometimes at a loss to the short seller. This is intentional—it penalizes short sellers who fail to borrow.

In rare cases, the SEC can issue a close-out order, requiring even faster settlement. During extreme volatility or naked short selling campaigns against specific stocks (e.g., heavily shorted micro-caps), the SEC may enforce stricter close-out timelines.

Exemptions and Special Cases

Market Maker Exemptions

Market makers are exempted from the Locate Requirement under Rule 10a-1(b). A market maker can short a stock at the offer price without locating, as long as the short is part of market-making activities (providing liquidity). This is necessary for market makers to operate—they must be able to short into strong bid interest without delay.

However, market makers are subject to close-out rules and cannot accumulate naked short positions indefinitely.

Threshold Securities

The SEC maintains a list of threshold securities—heavily shorted or volatile stocks where special locate and close-out rules apply. During periods of high short interest or multiple fails, threshold securities face tighter restrictions, including earlier buy-in deadlines.

Defined Circumstances Exemptions

In limited cases, the SEC may issue exemptive orders allowing short sales without locates (e.g., during a market emergency or for specific institutional transactions). These are rare and narrowly granted.

FINRA and Exchange Enforcement

FINRA (the Financial Industry Regulatory Authority) and individual exchanges (NYSE, NASDAQ) enforce Reg SHO through rule violations and surveillance:

• FINRA Rule 5210: Requires broker-dealers to locate shares before short sale execution
• Real-time surveillance: Exchanges flag trades that settle late or fail repeatedly
• Exam findings: SEC and SRO examiners identify locate ticket gaps and inadequate borrow procedures

Violations can result in:

• Regulatory censures and fines (often in the millions for major broker-dealers)
• Suspension of short-selling privileges
• Reputational damage and loss of client business
• Capital charges for persistent fails-to-deliver

Impact on Short Sellers and Hedge Funds

For short sellers, the Locate Requirement has several practical effects:

• Borrow availability: Hot short ideas may become unavailable to borrow, capping short interest
• Borrow costs: Hedge funds pay prime brokers for stock loans. Locate verification adds operational costs
• Execution delays: In illiquid stocks, confirming a locate may take hours, delaying order entry
• Forced buy-ins: If the short seller fails to return borrowed shares, it is forced to buy back at market—creating unexpected losses

For market makers and institutional investors, the Locate Requirement is less disruptive because of exemptions and because their short sales are typically hedges tied to specific trades.

See also