Borrowing and Lending Shares for Short Selling


Q.: Why on earth would someone lend me shares which he paid good money for when your intention is to profit from the shares falling!!?

A: Traditionally fund managers and pension funds frequently lend shares to short-sellers. Not only that but very few institutions and large investors actually hold the share certificates and do all the paperwork for registration and dividends: shares are held by custodians, and stock-lending is a nice little fee-earner for them.

Part of the difficulty for the small private investor is that for a fund or similar to accumulate enough money to finance a pension the fund must also speculate. This may sound too simplistic to those-in-the-know, but if you own a share for which you paid, say, £4 then the only way to make money is to wait until someone will want to buy it off you for more than £4. By facilitating shorting, and presumably taking a cut of any profit or charging the borrower a fee, the lender gets to keep the share whilst participating in any fall in value which, after receiving the cut or fee, might compensate for any drop in value. In exchange, the shorter (the borrower of the share) gets to make a few bob if the sp falls as presumably the shorter expects it will.

In practice the whole transaction is done by means of a 'repurchase agreement' (or 'repo'). This means that you actually sell the shares to me for say $10,000, but at the same time we agree that I will sell you those shares back in, say, a week for $10,020 (regardless of what they are actually worth then). Effectively, you lend me the shares and I lend you $10,000 and you pay me $20 in interest, but in practice I am now the legal owner of the shares, so I can very easily sell them (no misleading the buyer there!). All I have to do is buy them back within a week's time to return them to you.

The fees for stock lending that custodians and their clients (i.e. the super funds) earn would, over all, add up to far more than the perceived damage that is done by shorting. So in effect the custodians lend shares because they are then able to charge interest.

 

Q.: Ok, but who is in practice lending me shares when I go short on a CFD trade?

A: Lenders of stock will make 'stock loan fees' of say a few hundreds of a percent to 5% or more annualised. if you are a long term holder of the stock, why not lend them out? In some situations lenders can be shareholders, however brokers also lend out stock that is held in their nominee accounts. They take a risk that the holders of the stock are not going to want to sell their stock, but the broker will pocket the stock loan fee. So in most cases, when you borrow stocks to short you are borrowing them from your broker. Otherwise, they can also get it from one of the firm's customers or even another brokerage firm or institution holding the stock. Thus, if you would like to borrow a lot of stock, you need to speak to the brokers' stock loan desk who have a registry of shares available and the cost.

Q.: During the short period does the LENDER actually own less shares?

A: Borrowing shares is like borrowing money; at some point you must return them. The risk to the lender is that the borrower goes broke before he returns the shares. The lender makes a charge for the service which depends on his view of the risks and may ask for return of the shares if he considers that the borrower's losses are reaching a critical point. The borrower may pay an additional charge to extend the period of the loan (a roll-over).

Q.: Are underlying shares actually borrowed and sold if I create a short position with a CFD?

A: It depends upon the CFD provider. Remember a CFD is a private bet with your provider - they could be left out of pocket. As a result, the majority will not accept a CFD order unless they can cover their risk by executing a required covering trade in the market. E.g. if you wish to short a stock, but shares are not available, then they may not take your order.

Most providers will always cover. Some will use their discretion, based on the fact that n00bs usually lose (and their losses are a valuable income stream), and that very good traders tend to know something, so betting with the customer may also be profitable. A number of provider offer 'direct market access' contracts for differences - in these, you get access to live market data, and you place the hedging trade for them. Your position is taken at the exact cost of the hedging trade plus dealer's spread.

Q.: What's the logic of a broker paying interest if you go short if you still use margined trade with borrowed money?

A: Because you've 'sold' the instrument. Thus, in a way, they owe you money till you close the bet by 'buying' it back.

Q.: But where do brokers get the money to pay the interest on a short account if they don't have an opposing long position?


It is my understanding that usually interest is charged on long positions and credited on short positions. But where do you get the money to pay the interest on a short account if you don't have an opposing long position? I'm saying usually because I'm aware that currently one has to pay on short positions due to Libor being so low but what if it were 5% say.

A: As the CFD broker has sold the stocks to go short they receive money from the buyer and the broker then has to borrow the stocks and pay a rate of interest for that, when Libor is higher the money paid to borrow the stock is less than the money received from having the cash to enable the broker to pay interest to the short party.

However, in practice knowing who pays financing to which party isn't really going to help you be more successful so it makes more sense to accept the fact that you get charged interest on long positions and receive some interest credit on short positions (the level of interest on short positions is dependent on Libor which I believe is zero at the present time).

Q.: But you should have to buy something before you earn the privilege of being allowed to sell it!

A: The entire economy is built on borrowing assets and then selling them so it is hard to make this argument consistently unless you are also going to condemn the practice of borrowing to buy a house. Although this is not far from the position that proponents of Sharia law would adopt, condemning much home mortgage lending as usury.

Tesco and the like, do this all the time. It's the business model. They take delivery of products, on account, and sell to the customer, Take the money from the customers' bank immediately and pay the supplier 30, 60, 90 or 180 days later. They hold the risk of not selling, i.e. breakages, stolen or holding Easter eggs in June.

I would say that if this was not employed the cost of shopping would go higher. Pension funds loan shares for a return - the current share price in not an issue to them for the loan term, in normal circumstances, this is designed to increases the pension fund value most people will/do rely on.

Let's take the car example: a car broker (i.e. Bill and Ben the Car Shop Men) take an order on a Porsche 911. They don't own the car yet, but they take a deposit anyway. Then, they phone up Porsche, and buy the car. They always intend to deliver the car, and if Porsche changes its prices they have to pay the difference. The car buyer goes away happy, the broker goes away happy, and Porsche is happy. If the car broker didn't short Porsches, the car buyer would go to another garage that does short Porsches.

Taking the house example: A property company is building houses. Rather than fund the entire deal themselves, they invite people to look around an example house, and the buyers like what they see. They agree to buy the property and fork out a deposit. The deposit allows the property company to borrow money from the bank, and then build the house. If the cost of building the house goes up, the property company normally has to take the loss on the chin. If the property company didn't short-sell houses, they couldn't build as many, and the price of houses would be much higher.

Short selling is a normal feature of a working market. I can find examples of all kinds of markets where it occurs - from your yearly Christmas turkey to groceries from Tesco's direct, from luxury yachts to shoes.


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