I knew what internal and exchange shortages were but now I've forgotten.

Suppose I short-sell and forget to close the position, and my broker has the shares, then he will give them to the exchange temporarily and later buy them from the market and charge me the penalty - this is internal auction, right? So when the broker doesn't have the shares its an internal shortage which he then passes on to the exchange and it becomes an exchange shortage?

Is it possible that I sell shares from my demat account but my broker uses those shares to close someone else's short-selling?

A broker is not allowed to use his own shares to meet delivery obligations of his clients.
A broker is not allowed to use clients' shares to meet his own proprietary delivery obligations.
A broker is not allowed to use shares of one client to meet delivery obligations of his other clients.

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"Internal shortage" basically means a shortage in which the exchange is not involved.

"Internal shortage" means shortage is intra-broker, i.e. between the clients of the same broker.

A broker may have many clients and these clients may trade in the same stock.

Suppose three clients of an NSE broker trade in IFCI.

At the end of the day, these are the net positions of the three clients:

Client 1 buys 1000 IFCI shares.
Client 2 sells 2000 IFCI shares.
Client 3 buys 500 IFCI shares.

In all, 1500 shares have been bought and 2000 shares have been sold by the clients of the same broker.

The net of these three positions is 500 shares sold.

The broker doesn't have to deliver 2000 shares to the exchange, but only 500 shares, which is the net position.

That is how the settlement mechanism works. Brokers have to deliver net cash and net shares to the exchanges.

The rest 1500 shares, the broker will have to deliver directly to Client 1 and Client 3.

Suppose Client 2 does not deliver the 2000 shares.

In that case, there will shortage at exchange level (500 shares) and also an internal shortage (1500 shares).

The exchange level shortage will be closed as per NSE's policy.

The internal shortage will be closed as per the broker's policy.

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Do both internal and exchange level auctions bring the same loss?

No.

Exchanges either buy the shares from the auction market or close out the position on cash basis.

The auction market is not very liquid and sometimes the auction price is much higher than the current market price.

Every broker has a different policy for handling internal shortages and thus the loss of a client will depend on the broker's policies.

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How can I know whether my shortage (in my account when I sold) is internal or exchange level shortage?

You will have to ask your broker about it.

If it's a liquid scrip and you traded via a big broker, most probably, it will be an internal shortage.

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