When you're selling something you don't own you're distorting the market's price discovery mechanisms. In many contexts I think most people would consider it fraudulent to sell something before you've bought it.
How? It only does so if one sets out to do it on purpose, and in that case there is no difference between selling something that own, or that you don't (yet) own.
Let's say I sell grain to you for 300 USD per ton, to be delivered in Fall 2012. How does that distort the market? Alternatively, how is this example different from naked selling? Or isn't it, and do you think that this sort of insurances should be prohibited too?
"In many contexts I think most people would consider it fraudulent to sell something before you've bought it."
I'm not sure. There are many retailers who only order something from their wholesaler or manufacturer after you've bought it from them. Why would a buyer be concerned with when or how a seller gets his merchandise? It only becomes a problem after failing to deliver the goods, and when no adequate compensation for such a failure can be given (i.e., a seller going bankrupt because of a naked sale gone wrong). Something that could be controlled, regulated or mitigated in many ways that are much less intrusive than forbidding 'naked shorts'.
From the article: "In other words, 107% of all Overstock shares available for trade were short – a physical impossibility, unless someone was somehow creating artificial supply in the stock."
That is to say, there were more Overstock shares in the market than actually existed, because they were borrowed from thin air.
With a retailer, the merchandise will get delivered, and then the buyers will have it forever. With 'naked shorting', the merchandise is created from nowhere, lent out, sold, rebought, returned, and then disappeared. The shares never actually exist. But they affect the market as if they do exist - e.g. more shares existing in a company means every share is less valuable, so by magicking these shares into existence the price is equally magically dropped, which helps makes the shorting auto-succeed. It is straight up cheating.
Imagine a grain holding company lends you some paper 'shares' that are stand-ins for X amount of grain. It produces many of these shares, flooding the market with 'grain', and as a result the price falls. At this point their lenders buy up the grain from grain farmers at these lower prices, thus making a profit, and then return the grain to the company who then hands it out to the people who bought the shares. In this way, the grain farmers lose money because their product is devalued, while the company and its investors make money. This is the only mechanic at play: money flowing from the people who create value into the pockets of the market manipulators. Oh, and this 'grain holding company'? They never had any grain to begin with. All they had was the know-how and connections to lie and get away with it.
This is a situation that would be EXTREMELY unusual because it's very, very dangerous for the short sellers. I could recall all my lent out shares and unless I sell one of the shares I own there is no way for the short sellers to deliver so the price will spike into the stratosphere due to a short squeeze.
The fact that short sellers were willing to short stock despite the massive short interest (which is a publicly available number) means the market as a whole believed that OSTK was wildly overpriced, which in hindsight it was.
Why does it matter that there are more shares being traded than that actually exist? It isn't about the actual trades, it's a simple contractual thing - one party promises something, the other agrees to pay for it, and as long as both end up satisfied, that's it. There is no 'merchandise being created from nothing', it's just one party promising to do something, that's it.
"e.g. more shares existing in a company means every share is less valuable"
This doesn't make sense - there are no shares created. There is a party promising to deliver shares, that's completely different.
There are lots of "don't have it yet" processes. Consider the typical loan. The borrower typically doesn't have the money at the time that the loan is made.
Anyway, the futures market has functioned for centuries with people buying and selling what they don't own, and the big institutional buyers and sellers commonly use futures prices as their benchmark prices. It looks like the smart money isn't too concerned about negative effects on price discovery.
Also, let's not confuse playing by the clearly established rules of the market with "fraud". Moral objection is no excuse for equivocation.
However, with naked short selling it's a different story. When you're short selling something that you don't own you're in effect making it look like the supply is bigger than it actually is. This distorts the price discovery mechanism.
So what's the objection? If you buy, hold, and sell, you want prices to be overall lower. Selling low isn't bad if it means you were also buying low. In short, as Warren Buffet likes to point out, low prices are good for investors.
They're not pretending to follow the rules of the market, they are actually following the rules of the market. Having actual posession of the item at the precise moment of sale is not a rule of the market in question. Lay investors still get their shares delivered, so I have no idea what you're worrying about.
The fact that no one was willing to do that to OSTK stock tells you how shitty the company is and how overvalued the stock was.