The Role of Short Selling in Equity Markets
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To understand the role of short selling, one has to step back and try to understand how it impacts price discovery in equity markets. We are familiar with terminology such as short squeeze, prime brokers and short interest, but what does it all mean?
The history of short selling is almost as long as the history of equity markets. While the equity markets came first, written accounts of short selling date back to 1609 on the Amsterdam Stock Exchange. The impact of short selling is undeniable in today’s equity markets. One information provider, Markit, provides data on $15 trillion of loanable securities and $2 trillion securities on loan. Chart 1 shows the inverse correlation between short selling and the 2011 European debt market crisis. In September 2012, the Federal Reserve announced the third round of quantitative easing (QE3), which was bullish for equities, and saw short interest fall for an extended period as printed money became a contributing factor to a rising S&P 500. The latest spike in short selling since the summer has been even more dramatic, coinciding with a correction in the Chinese equity market.
What exactly is short selling?
If an investor disagrees with the valuation of a security, he or she can short sell the security, which is the opposite of buying a security. To profit, the investor needs to sell the security short, have the security fall in value, and then buy the security back at a lower price.
Price discovery represents the balance of those who approve and those who disapprove of a security’s valuation. Daily price corrections reflect the balance between supply and demand and incorporate the impact of news flow on the future earnings associated with a security.
But how can the disapproving investor sell what they do not own? The mechanics of a short sale require the disapproving investor to borrow the security from an investor that holds the security. The borrowed security is then sold, and 100% of the cash generated is deposited in a margin account. The Federal Reserve Board requires all short sale margin accounts to maintain collateral equal to 150% of the value of the security sold short, so an additional 50% worth of collateral is required to initiate a short sale. The lender of the security, typically a broker-dealer, also charges interest on the borrowed security and dividends received by the short seller, which must be passed through to the security lender. The lender of the security also retains the right to recall the security if a special event occurs.
Let us assume the short seller is right and can buy back the security in the future at a lower price, profiting after paying fees, dividends and interest. The shares bought at a lower price are delivered to the security’s lender who returns them to their original owner, and the short sale is closed out. The brokers who facilitate securities lending are called prime brokers, which is often a division within an investment bank’s broker-dealer arm. The security holder is called the beneficial owner, which in financial markets is often called the custodial bank.
Who lends securities?
Securities lending is a long-standing practice that allows broker-dealers to avoid delivery failures associated with trade settlement. Prior to the adoption of electronic settlement in the 1970s through the Depository Trust & Clearing Corporation (DTC), broker-dealers had to physically deliver securities for trade settlement. Weather and logistical issues led to a practice of lending securities to reduce settlement risk. Lending is now common practice among institutional investors, such as closed-end investment companies, insurance companies, pension funds, exchange-traded products (e.g. ETFs), college endowments and unregistered investment funds. When retail investors borrow on margin, typically the custodian can lend the securities posted as collateral. In 1981, the Department of Labor amended its Prohibited Transactions Exemptions to allow pension funds to lend securities more freely, which dramatically increased the number of securities available for lending.
The evolving complexity of the financial markets means there is counterparty risk. Lehman Brothers’ bankruptcy sent shock waves through the financial markets. One reason for the turmoil was that Lehman Brothers acted as prime broker on billions of dollars of borrowed and lent securities, and overnight the counterparties were denied access to their collateral.
This article focuses on equity securities lending, but to understand the securities lending market, one has to look at the interaction of the financial intermediaries involved. Securities can be borrowed from a custodian, who acts as an agent. Another option is to use a third-party agent. There are two banks in the U.S. -- J.P. Morgan and BNY Mellon -- that act as third-party agents. Charts 2 and 3, below, show fixed income obligations, and central banks, investment banks and money market funds are important players in the securities lending market.