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I used to work for an investment banking firm on their securities lending desk. Our business revolved around short selling and lending attractive and thinly traded US and International (European & Asian) stocks from large institutional clients (Mutual Funds, Pensions, and Endowments).  Our business was to lend these stocks to counterparties (UBS, Merrill Lynch, Morgan Stanley) who wanted to ensure that their clients had “covered” short positions in the market. By borrowing the stock, they were able to hedge their losses and protect themselves from two scenarios: If the stock was to rally and increase in price they would be protected from large losses since they are borrowing at a specified rate and could extend the lending contract to wait for the stock to fall in price again, the second scenario is with thinly traded companies (Small to Mid-Cap Companies) that issue small amounts of stock, if there is a great deal of short covering occurring in a stock, it may result in a “Short squeeze” wherein short sellers are forced to liquidate their positions at progressively higher prices as the stock moves up rapidly.  

All of counterparties that we had lending agreements with, would not allow clients to participate in “naked” short selling, which entails shorting stock but not having any ownership or participating in securities lending . This practice of “Naked shorting” has become an illegal practice it allows manipulators a chance to force stock prices down without regard for normal stock supply/demand patterns. In 2008, the Securities and Exchange Commission (SEC) amended Regulation SHO to further limit possibilities for naked shorting by removing loopholes that existed for some broker/dealers. Regulation SHO requires lists to be published that track stocks with unusually high trends in "fail to deliver" shares. Some analysts point to the fact that naked shorting, albeit inadvertently, may help markets stay in balance by allowing the negative sentiment to be reflected in certain stocks' prices. (http://www.sec.gov/rules/final/2009/34-60388.pdf)

From my experience with securities lending and short selling, these activities are blamed for forcing the overall markets to decline in times of market stress. The problem with shorting during the financial crisis was those individuals who were in the practice of naked short selling. The SEC felt that banning short selling would help to ease some of the market stress that was being put on the financial companies.  

The interesting aspect that the SEC ignored was the fact that short sellers were among the first to raise alarm about the risky mortgage lending practices that led to the financial crisis. In Michael Lewis’s “The Big Short” he talks with traders, analyst and a hedge fund manager who took $110K and turned it into $120M when the market crashed. All of these individuals see how the financial companies had profited from issues risky mortgages and took advantage of the opportunity. That is what capital markets is all about, would we penalize the individual who bought Apple at $3 in 2004 and held it to its high of $700 and then sold the position? A recent study from the University of Buffalo School of Management found that short sales have a positive impact on the markets.  The study examined 1,492 New York Stock Exchange and 2,381 Nasdaq common-share trades from January 2005 to June 2008 and the results show how restricting short sales hurt the market. Restricting short selling actually affected market liquidity and significantly reduced pricing errors, order imbalances and volatility over a single day. http://www.buffalo.edu/news/releases/2014/07/042.html

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