Some people say short selling is bad because short selling causes prices to fall, which makes people who own stocks poorer and ruins companies. This is nonsense. If a stock price falls, that is bad for anyone who intends to sell that stock, but good for anyone who intends to buy that stock. If a company's stock price falls because of short selling, the company's revenue and expenses are unchanged and the company can ignore the low stock price and continue business as usual. So if the company goes bankrupt, that company probably would have gone bankrupt anyway even if there had been no short selling.
Short selling cannot drive the whole market down. Short sellers receive money when they sell stocks. Short sellers either use the money to buy other stocks, or deposit the money in a bank. The bank lends the money to other people. Eventually the money comes back into the stock market, and causes stock prices to rise. So short selling causes prices to rise as well as fall, and the two effects should cancel each other out, and short selling should have no effect on the whole stock market. However, the two effects might not occur at the same time, so short selling might increase short term volatility.
Short selling is a threat to the integrity of the stock market, but not for the reasons usually given by critics of short selling. Short selling is a heads I win tails you lose proposition. If the short seller wins, the short seller makes a lot of money, and the short seller gets to keep all the profits. If the short seller loses, and the short seller cannot cover the losses, then the short seller is bankrupt and the short seller's losses are shifted onto other people.
Short sellers should have reserves in case of losses, but there is a risk that the losses might be greater than the reserves. It is not practical to require short sellers to have sufficient reserves to cover the maximum possible loss, because the maximum possible loss is infinite, and it is not practical to require short sellers to have infinite reserves. The risk that short sellers' losses will exceed short sellers' reserves is shifted onto other people. Ideally this risk should be shifted onto people who voluntarily agree to accept this risk. If that is not possible, then the people upon whom the risk is imposed should be compensated. This is why short selling should be regulated.
A simple solution would be to require short sellers to buy bankruptcy insurance. However, this is not a perfect solution because there is still a risk that the short seller's losses will be greater than the insurance company's reserves.
Suppose a short seller borrows a share of stock from a stock lender and sells the stock to stock buyer. The short seller then goes bankrupt and the stock lender demands the share of stock back from the stock buyer. The stock buyer did not know that the stock was borrowed. The stock buyer did not know that this was a short sale. So it is unfair to shift the short seller's losses onto the stock buyer. The stock lender knew this was a short sale, volutarily agreed to participate in the short sale, and was paid a fee for the loan of the stock by the short seller. The stock lender should have understood the risk of the short seller going bankrupt, and should have demanded a fee high enough to compensate. So when the short seller goes bankrupt, the stock buyer should keep the stock, and the stock lender should lose the stock. The short seller's losses should be shifted onto the stock lender, not onto the stock buyer. The stock lender should have no right to demand the stock back from the stock buyer.
Also, if there is a corporate election, the stock buyer should vote that share, not the stock lender. The stock lender should lose the right to vote when loaning the stock to the short seller. A stock loan must include all rights associated with the stock, including voting rights, dividend rights, etc.
Naked short selling is bad because no one agreed to accept the risk of the short seller going bankrupt.
It is impossible for a person to engage in naked short selling without assistance from stockbrokers. One could argue that by choosing to facilitate naked short selling, stockbrokers are choosing to accept the risks of the naked short sellers going bankrupt. If a short seller places an order for a naked short sale with a stockbroker, and the stockbroker chooses to accept the order, the stockbroker is effectively lending the shares to the short seller. In other words, this is not naked short selling, but a failure of stockbrokers to keep proper records of and make proper disclosures of stock loans to short sellers.
It should be legal for the stock lender and the stock buyer to be the same person. In this situation, the short seller sells a phantom share of stock to the stock buyer/lender, and simultaneously borrows a phantom share from the stock buyer/lender. These phantom shares should have no voting, dividend, or other rights. The stock buyer/lender should understand that these phantom shares are not real shares and there is a risk the short seller might go bankrupt. The phantom shares are riskier and have fewer rights than real shares, so phantom shares should have lower prices than real shares. Thus an investor can increase total return by buying phantom shares instead of real shares, and eventually exchanging the phantom shares for real shares.
These phantom shares are very similar to stock futures, so maybe it would be simpler to prohibit all short selling, but allow unlimited selling of stock futures.
Another problem with short selling that many individual investors keep their stocks with stockbrokers. These individual investors do not lend their stocks to short sellers, but the stockbrokers sometimes lend the shares to short sellers. This is a problem because the stockbrokers are lending something which they do not own. If the short seller goes bankrupt, the losses are shifted onto the stockbroker. But if the losses are greater than the stockbroker's reserves, then the losses are shifted onto the individual investors, who had no knowledge of and did not agree to accept these risks. Deciding whether or not to loan shares to short seller is an investment decision. You must decide if the fees paid by short sellers are sufficient compensation for the risk, loss of voting rights, etc. If the individual investor did not give the stockbroker the power to make investment decisions like which stocks to buy, then the the stockbroker should not lend the investor's stocks to short sellers.
If the losses of short sellers are shifted onto a stockbroker, the stockbroker should cover these losses with profits from services rendered to short sellers. If the stockbroker's profits from services to short sellers are insufficient to cover the losses, then the stockbroker will have to make up the losses with profits from other customers. It is unfair to shift the short sellers' losses onto other customers. The stockbroker is undercharging short sellers and overcharging everyone else. As long as there is competition between stockbrokers, this is not a problem because the people who are being overcharged will change to a different stockbroker, and the stockbroker will be left with only the unprofitable customers and will go bankrupt.
Some people say that short selling distorts corporate votes, that corporations have difficulty determining who is and who is not allowed to vote in corporate elections. But if people who lend stocks are not allowed to vote, naked short selling is prohibited, and phantom shares are not allowed to vote, then any remaining problems are caused by bad recordkeeping, not by short selling.
Since losses from short selling are potentially infinite, some people might think that unusual circumstances might lead to unusually large short selling losses, which might be large enough to bankrupt enough stockbrokers to wreck the economy. This is not possible. Short sellers lose money when stock prices rise. Stock prices rise when the economy is prosperous. Unusually large losses from short selling can only occur during a time of unusually great prosperity. Losses from short selling occur when they are least likely to damage the economy.