Market Makers, Dark Pools and Naked Short Selling

Squeeze traders talk about market makers and dark pools as if they were villains or oracles. Both are better understood as plumbing. Plumbing decides what price you actually get, how much of the volume you can see, and how reliable your data is. This lesson explains the plumbing, what it does to a squeeze, and where the risks of naked short selling really sit. The goal is to replace stories with mechanics you can plan around.

1. Where an order can go

A US stock does not trade in one place. A buy order can end up in one of several kinds of venue.

All executed trades are reported to the consolidated tape, including trades that happen away from exchanges, which are reported through a FINRA trade reporting facility. The difference is what is visible before the trade.

2. Market makers: what they do

A market maker continuously offers to buy at the bid and sell at the ask. It earns the spread, takes on inventory, and hedges that inventory. Some are formally registered with an exchange and carry quoting obligations. Others are wholesalers who fill retail orders internally.

Three things matter to a squeeze trader.

They are intermediaries, not the thesis. A market maker who sells you shares is usually short that inventory briefly, then covers or hedges. That is a flow business. It is not the same as the directional short sellers who make up short interest.

They have a locate exception for bona fide market making. Regulation SHO requires brokers to locate shares before a short sale, with an exception for bona fide market making. Market makers sell short all day to fill buy orders and often finish close to flat. Those sales count in daily short volume but leave little or no short position behind. That is one reason short volume must not be read as short interest (see Playbook 2).

They adjust to risk. When volatility jumps, market makers widen their spreads, shrink the size they quote, and sometimes step back entirely. That is rational risk management and it is what you will meet in a squeeze.

Worked example: what a wider spread costs. You buy 1,000 shares at $12.00 mid-price.

In the squeeze case you are about 3.3% behind before the stock does anything. That is a reason to use limit orders, to size smaller, and to avoid entering on a market order in the middle of the fastest candle.

3. Payment for order flow and wholesalers

Many retail brokers route marketable orders to wholesale market makers, who often fill them at or slightly better than the national best bid and offer. The wholesaler may be paid for the order flow, and brokers must still seek best execution. For a squeeze, the point is structural:

• A burst of retail buying is absorbed by wholesalers first. They take the other side, build a short inventory, and then hedge or offload on exchanges.
• A one-sided retail flow therefore reaches lit markets with a delay, as hedging, and can add to buying pressure.
• Wholesaler prints are counted as off-exchange volume, which matters when you read dark-pool data (next section).

4. Dark pools

A dark pool is an alternative trading system that does not display its order book. Institutions use them to trade large size without showing intent and moving the price before the order is done. Many trades execute at the midpoint of the national best bid and offer, or within it.

Key facts:

• Reporting. Off-exchange trades are reported to a FINRA trade reporting facility and reach the consolidated tape shortly after they execute. Orders are not shown before the trade. FINRA then publishes weekly volume for each ATS and each stock on a delay: two weeks for Tier 1 NMS stocks and four weeks for all other NMS stocks and OTC equities. Most squeeze names are small caps outside Tier 1, so their ATS data is about a month old when it appears.
• Share of volume. A large part of US volume prints away from exchanges. The share moves around, so check FINRA's OTC transparency data for the period you care about instead of quoting a round number. Much of it is wholesaler internalization of retail flow, not institutional block trading.
• Types. Broker-dealer owned, independent, and exchange-affiliated pools exist.
• Not the same as hidden orders. A hidden or reserve order sits on a lit exchange book and is a separate thing.

What dark pool data can and cannot tell you

Vendors sell derived indicators built from off-exchange data and from options positioning. Those are model outputs with assumptions. Treat them as hypotheses.

5. Naked short selling

Definition. A covered short sale is made after borrowing shares, or arranging to borrow them, so they can be delivered at settlement. A naked short sale is a short sale made without having borrowed or arranged to borrow shares. That creates a risk of failing to deliver at settlement.

The rules. This lesson describes rules and market plumbing. It does not accuse any firm of breaking them. Sources are listed at the end.

• Locate (Rule 203(b)(1)). Before accepting or effecting a short sale, a broker-dealer must have borrowed the security, entered a bona fide arrangement to borrow it, or have reasonable grounds to believe it can be borrowed so it can be delivered when due. The broker must document this.
• Market making exception (Rule 203(b)(2)(iii)). Short sales by a market maker in connection with bona fide market making do not need a locate. The SEC says the exception is limited. It does not cover speculative selling or selling for the firm's own investment purposes, activity out of proportion to the firm's usual market making, quoting only at or near the offer and not the bid, or arrangements that help another broker or customer avoid the locate. Market makers are not excepted from the close-out and pre-borrow requirements.
• Close-out (Rule 204). A fail to deliver from a short sale must be closed out by borrowing or buying shares by the start of regular trading hours on the settlement day after the settlement date. A fail from a long sale, or one attributable to bona fide market making, must be closed out by the start of regular trading hours on the third consecutive settlement day after the settlement date. Sales of securities a person is deemed to own but cannot yet deliver, such as restricted stock, get up to 35 calendar days from the trade date. A firm that misses its deadline, and the brokers it clears for, must pre-borrow before any further short sale in that security until the closing purchase has cleared and settled.
• Threshold securities (Rule 203(c)(6) and (b)(3)). A threshold security has aggregate fails of at least 10,000 shares and at least 0.5% of total shares outstanding for five consecutive settlement days, and appears on an exchange or FINRA list. If a participant's fail in a threshold security lasts 13 consecutive settlement days, it must close the fail out by purchasing shares.
• Antifraud (Rule 10b-21). Deceiving a counterparty about the intention or ability to deliver by settlement is fraud when delivery then fails. Selling short and failing to deliver in order to push the price down is manipulation under other securities laws.
• Short sale restriction (Rule 201). After a covered stock falls 10% or more from the prior day's close, short sale orders may not be executed or displayed at or below the national best bid for the rest of that day and the next, with limited exceptions.

Deadlines in Rules 203 and 204 are set relative to the settlement date, so they follow the standard settlement cycle. For most broker-dealer transactions that has been one business day (T+1) since the SEC's compliance date of May 28, 2024 (SEC press release 2023-29). Some older SEC pages still describe T+2. Rules, lists and cycles can change again, so confirm against the current eCFR before you quote any deadline.

The SEC also notes that regulators have brought enforcement actions over manipulative naked short selling, and that naked short selling is not by itself a violation. For example, market makers may need to sell short before they can arrange to borrow shares in a fast market.

What retail traders can and cannot do. At a retail broker you cannot short a stock without a locate. For hard-to-borrow stocks, availability can be zero. That is a feature, not a bug, of the borrow market.

Who bears the risks

What this means for squeeze analysis

1. Fails to deliver are a clue, not proof. Many fails come from ordinary operational delays, such as late customer deliveries, problems obtaining borrowed shares in time, or physical transfer issues, and can result from long sales as well as short sales. The SEC publishes fails data twice a month, and appearing on the threshold list does not by itself mean abuse or imply anything negative about the issuer. A stock on the list deserves attention because a fail that lasts 13 settlement days must be bought in. But the SEC says close-out purchases do not necessarily drive a price up, and that the purpose of Regulation SHO is to clean up fails, not to cause squeezes. Timing and size of any buying are hard to predict.
2. Reported short interest counts positions, not their legal status. A short sale the seller never borrowed for is still a short position, so it still counts in reported short interest. When a fail exists, the seller still owes the shares. Closing the fail later means buying them, which is future forced buying with an unpredictable date.
3. Short interest above 100% of float does not by itself show naked shorting. A share that is borrowed and sold short can be bought by someone who lends it out again, so one share can sit behind more than one short position. The SEC staff report on the January 2021 meme-stock episode says short interest can exceed 100% "when the same shares are lent multiple times by successive purchasers," and records GameStop short interest at 122.97% of float that month.
4. A belief in a huge hidden short is a trading hazard. Traders who assume a hidden short must be forced to cover can hold through a collapse, waiting for a squeeze the data does not support. The SEC specifically warns that issuers, promoters and shareholders may post unfounded claims online about large naked short positions and an imminent squeeze to stimulate buying. Treat claims of hidden shorts as unverified until they appear in data you can check, such as the SEC fails-to-deliver files and the exchange threshold lists.
5. Close-outs are not a timetable. Even when a close-out is required, the buying can come in size, in pieces, or from a party with a deep cushion.

6. Myths and mechanics

7. Putting it into practice

• Expect wide spreads in the acceleration stage. Use limit orders and size smaller.
• Treat displayed depth as a floor on liquidity, not the whole picture.
• Use total volume for relative volume, and do not infer direction from dark prints.
• Check the threshold list and fails-to-deliver trend as context, never as a trigger.
• Check borrow availability and recalls (Playbook 2) before believing a squeeze story.
• Know your broker's rules for restricting or halting trading in volatile names.
• Do not trade the claim that an unseen short must cover. Trade what the verified data shows.

8. Mistakes

• Reading short volume or off-exchange volume as direction.
• Assuming high dark-pool share means institutional buying.
• Treating fails to deliver as a prediction.
• Believing hidden-short stories without data.
• Entering with market orders into a widening spread.
• Ignoring that market makers can step back exactly when you need them.

9. When this analysis fails

• Venue data is aggregated, delayed and sometimes mislabelled by vendors.
• Fails-to-deliver data is published with a lag and is noisy.
• Rules and deadlines change. Check the current rule text before you rely on a deadline.
• You cannot see who is on the other side of any single trade.

Key Takeaways

Sources

• Regulation SHO Rules 201, 203, 204 (eCFR): https://www.ecfr.gov/current/title-17/chapter-II/part-242/subject-group-ECFR3dd95cf4d3f6730/section-242.201 , https://www.ecfr.gov/current/title-17/chapter-II/part-242/subject-group-ECFR3dd95cf4d3f6730/section-242.203 , https://www.ecfr.gov/current/title-17/chapter-II/part-242/subject-group-ECFR3dd95cf4d3f6730/section-242.204
• SEC, Key Points About Regulation SHO: https://www.sec.gov/investor/pubs/regsho.htm
• SEC, Fails-to-Deliver Data: https://www.sec.gov/data-research/sec-markets-data/fails-deliver-data
• FINRA, Short Interest Reporting: https://www.finra.org/filing-reporting/regulatory-filing-systems/short-interest
• FINRA, Short Interest: What It Is, What It Is Not: https://www.finra.org/investors/insights/short-interest
• FINRA, Understanding Short Sale Volume Data (Information Notice, May 10, 2019): https://www.finra.org/rules-guidance/notices/information-notice-051019
• FINRA Rule 6110 (OTC and ATS volume publication delays): https://www.finra.org/rules-guidance/rulebooks/finra-rules/6110
• FINRA, OTC (ATS and Non-ATS) Transparency: https://www.finra.org/filing-reporting/otc-transparency
• SEC press release 2023-29 (T+1): https://www.sec.gov/newsroom/press-releases/2023-29
• SEC Staff Report on Equity and Options Market Structure Conditions in Early 2021: https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf

Related: Order Flow and Equity Microstructure, How Stock Markets Work, Short Selling and Short Squeeze Mechanics, Volume Analysis for Stocks.