100% of float isn't necessarily the point where short interest gets dangerous, and an individual share (imagine you tag it and track it) can be sold short and lent out again for short sale in repeated transactions, even if short interest is nowhere close to fully saturating the float. The point where shorts equal the float is simply a salient mile marker. When shorts cover aggressively or get liquidated, natural sellers who figure out what's going on will hold out for a higher price because they know the bid will persist. All of this is tied into the problem with no-locate short selling. Market-makers have a profit motive to offer shares below where the natural sellers would be offered, because in addition to profiting from the dislocation between trade price and the value of the asset, they also profit from encouraging two-way activity because it means more business for them. It plays out like this:
* ShortSeller Capital chases the stock higher as it covers a toxic short in XYZ stock,
* XYZ stock gets so elevated that market-makers can't resist selling it short despite having no borrow in the name,
* ShortSeller Capital has handed its short off to a market-maker who will patiently work itself out of the short shares.
Here we encounter one of the problems with the locate exemption for bona fide market makers. There's no need for a natural seller to be involved in a short-covering transaction, even if there is zero borrow available to market-makers. In other words, the market-makers sell something that they have no means to deliver, but the regulations give them extra time to wait for it to materialize in the market later. The clearinghouse carries counterparty risk against the market-maker in the interim.
If the market-maker cannot buy or borrow in time, the problem loops but you get one fewer market participant who is willing/able to sell the shares, and therein lies the runaway condition.
> The practice itself is healthy because it encourages the uncovering of fraud
I reluctantly agree with this oft-repeated refrain. Long holders have an equal or greater incentive to discover frauds when compared to short-sellers. The difference is that short sellers have a greater incentive to draw attention to fraud. After longs close, they have very little reason to share suspicions of fraud because there is zero financial upside and some reputation risk involved.
Yet presumably in so highly regulated an industry as high finance, is the job of government to enforce laws and uncover fraud.
> the practice is necessary for derivatives hedging
Equity derivatives hedging would get very complicated without short selling, price discovery would get weirder, and liquidity would obviously get thinner. That said, I doubt a weakening of put/call parity would hurt the economy in any meaningful way. It's not the same as, say, commodity derivatives where being short a future is a straightforward position for producers, and where options on futures can serve as a form of insurance for firms whose operations depend on the underlying commodities. In the equity market, who really needs to own a put if they can simply sell the stock or trade CDS? How much of the institutional volume is hedge fund speculation that provides essentially zero utility to people outside of the institutional equities business?