Short selling, who loans their share?

January 5th, 2010

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Recently, one of our readers asked,

I can see how Naked Short Selling is fraud, but I can’t figure out who would knowingly loan shares to someone who wanted to short them? What interest do they get on the loan of shares or risk premium that they will be returned? I am assuming you have to have permission to borrow and sell someone else’s shares and they need to be compensated for the privilege. Especially when some one long company ABC wants to see the stock go up, and keeping their shares off the market helps create the lack of supply that helps that upward dynamic. So why help someone who wants to go short and what do you get from it? It would be great to see a Post about this whole issue of shorting. Especially when I want to sell something short, who have I asked to borrow the shares?

First, for the beginners, let’s explain what short-selling is. Basically, it is a way for traders to profit from falling stock prices. This is how it works:

  1. The trader borrows stocks from someone else.
  2. Then the stocks are sold on the market.
  3. Later, the trader buys back the stocks on the market.
  4. The stocks are returned that someone else.

Between step 2 and 3, if the stock prices fall, the trader will make a profit. On the other hand, if stock prices rise, the trader will make a loss.

What is naked short-selling?

No, it has nothing to do with nudity. Basically, in naked short-selling, step 1 is omitted and in step 4, the stocks are delivered to the buyer instead of to the ‘someone else.’? That is, the trader sells the stocks first without arranging to borrow it from someone else.

The next question you may ask is, how can selling stocks without having any on your hands be possible? If you are a retail investor trading through say, your Internet-based discount broker, it is not possible. This is because most brokers will not allow you to send any sell orders to the market if you don’t own the stocks in the first place. But for traders with the ‘connections’ or independent access to the market, it is possible. Usually, these are the institutional traders. To understand how it works, imagine you are a bidder for a painting in an auction market. You have no money in your bank account. But does that prevent you from placing a bid for the painting? No. The auctioneer is not going to search through all your assets to make sure you have the cash at bank. You can still bid for the painting. But should your bid be successful, you will be legally obliged to cough out the cash. In the same way, the stock exchange is basically an auction of stocks.

You can certainly come up with a short-sell arrangement with your friend. You may borrow your friend’s stocks (by filling in a securities ownership transfer form), sell the stock on the market (through your broker), buy back the stocks later (again, through your broker), and then return your friend’s stocks (by filling another securities ownership transfer form). To be fair, you will also compensate your friend any dividends foregone in the interim period that the stocks are not under his ownership.

If your friend is your bosom buddy, he may verbally agree to such an agreement for free. But in the real world of money, there are legal obligations involved. The terms of loan of stocks will be governed by law, which requires that the stock borrower provides the stock lender with collateral in the form of cash, government securities or letter of credit. Both parties will negotiate a fee for this loan arrangement. If cash is used as collateral, then the borrower is entitled to the interest earned on the cash, of which the borrower may rebate some of the interests as part of the lending fees.

The fees are where the motive for lending stocks come from. Stocks usually pay dividend once or twice a year (or maybe not at all if the business is at a growth phase). Other than that, it is an ‘idle’ asset. If you can lend stocks to short-sellers for a fee, then you will be earning additional income from your stocks. From the point of view of the lender, if he does not have the intention to sell his stocks, then this seems to be an opportunity to earn additional income for nothing- after all, the stock borrower has to compensate the stock lender for any dividends foregone. Indeed, we have seen such an arrangement packaged as financial ‘products’ to entice retail investors to permit their stocks to be lent out. Worse still, we have read newspaper reports of superannuation funds lending out their stocks to short-sellers in order to earn fees to bump up the returns of the funds.

Who are the ones lending the stocks? There is a class of institutions called the “Security Lenders” who have access to ‘lendable’ securities. They include asset managers who have many securities under management (e.g. your superannuation funds), custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder’s custodian. These institutions include big names like Citibank, Deutsche Bank, Goldman Sachs, HSBC, etc.

Of course, when it is a bull or stagnating market, lending stocks for a fee is a no-brainer way to earn additional income. After all, it is the short-sellers that bear all the risk of losing money in a rising market. The stock lender carries no risk at all as long as stock prices do not plunge.

But when it is a vicious bear market, short-sellers will be the ones making a killing while the stock lenders carry all the losses. That is what happened during the Panic of 2008. Naturally, the supply of stocks to be lent out dried up in such an environment. In a bear market, when everyone wants to sell stocks, no one will be lending them out to short-sellers. That is where naked short-selling comes in. Because short-sellers cannot find stocks to borrow (or the fees were exorbitant) in the Panic of 2008, they naked short-sell.

Naked short-selling becomes a problem when the short-seller fails to deliver the stocks to the buyer. This will result in systemic to the financial system if allowed to go out of hand. During the Panic of 2008, there were newspaper reports of hedge funds deliberately failing to deliver the stocks. By naked short-selling, those hedge funds received payment for the stocks from the buyer first. Then the payment was used to earn interest. As the penalty for failing to deliver the stock was less than earned interest, it made financial sense to drag out the non-delivery of? stocks for as long as possible. In theory, an infinite quantity of stocks can be sold through naked short-selling, overwhelming the market into panic with an avalanche of phantom stocks for sale.

Until not long ago, retail investors do not have access to short-selling. This is because short-selling is seen as too ‘risky.’ This is because in theory, the potential loss of a short-seller is infinite because the upper limit of stock prices is infinity- practically possible in money-printing nations like Zimbabwe. But nowadays, even retail investors can short-sell with their online brokers (e.g. CommSec, Macquarie Prime) either in the form of traditional short-selling or via CFDs (a financial instrument that is not available in the United States).

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P.S. We will continue the story from our previous article in the next article.

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