Who are players in this market? Many major broker/dealers, banks and large institutional investors have stock-loan departments. Entities that control or own large portfolios have the ability to run or out source a stock-loan department. Custodial banks, and Prime Brokers may help large clients establish lending programs for their portfolios. Brokers have the right to lend stock that is bought on margin (see the re-hypothecation clause in any standard margin agreement).
As stated in our article on short selling, the short seller must locate a stock borrow and obtain a locate identifier before entering the order. The stock loan department enters into the picture by securing the stock to be borrowed and providing the locate identifier to traders or investors who are selling short. Once you locate the stock to borrow it’s important you know your obligations before you actually short the stock. Obviously, if you don’t trade you have no liability but if you decide to short, know your rights and obligations. So let’s define the stock borrow. As with any other loan you are obligated to return it either at a specific time (term) or (open) at the request of the rightful owner. The key to understanding the stock-borrowing concept is to understand you do not own the stock! Therefore, you are not entitled to the stock dividends; in fact you are obligated to pay them. This includes dividends in the form of regular quarterly dividends, special cash dividends, stock dividends, or stubs are all due to the rightful owner of the stock. Anything the owner of the stock is entitled to he or she will receive it at he borrower’s expense. In short, as the borrower you do not have the rights of ownership, voting or otherwise.
Possible problems you must know before you short a stock.
A problem exists when you still have a need to borrow a stock while at the same time the rightful owner decides to reclaim his property. If your stock loan department can find an alternate borrower there is no problem but if no alternate can be found you will be forced to “buy in” the stock to satisfy the lender. This may require a unwinding of the trade before you would like, and in some cases will produce losses. A good example of this would either be a short squeeze or an arbitrage trade known as a reversal. Unless you have a term agreement that is still in effect you are required to return the borrowed stock at the request of the lender. Right? This is technically and legally true but we have all heard the story of the 800-pound gorilla. Ok, so like in every other aspect in life if you’re the small retail client you’re toast. Translation I don’t want to hear it, return the stock now! However, if you’re a player, or the 800 pound gorilla, there maybe an exception. Say broker/dealer ABC owes institution XYZ, which in turn owes bank MMM. If MMM demands a return of the borrowed stock, ABC fails to XYZ, XYZ fails to MMM creating a daisy chain of fails. Since MMM is the anchor in the chain they’re in control. In this case a professional courtesy would be extended if possible due to potential repercussion, as it’s only a matter of time before the roles will be reversed and MMM will need a favor from either of the other two counterparts. Besides until the stock is returned the monies or collateral is kept and continues to earn interest without payment of the rebate* due to the fail. And that’s how the 800 pound gorilla’s sleep were ever they want.
*Rebates are interest payments made to the party who borrows the stock and whose proceeds are used as collateral. Denial of (zero) or reduced rebate payments make borrowing more expensive for the small retail investor - an important calculation to made when considering a short sale. When trading desks borrow stocks they give the proceeds as collateral but also expect the collateral holder to pay interest on those funds. After all it’s not the collateral holder’s money- they are just holding the funds as collateral while lending their stock. Rebates to the short seller are usually credited once a month by most brokerage firms. The rate paid on a security is determined by its availability: the harder a stock is to find the less the lender will pay to the borrower. Unfortunately most retail players like yourselves will receive a zero rebate rate for your collateral. This is one way the stock loan departments of brokerage firms make money. And if you’re a bigger retail account and do receive rebate interest it is very doubtful you will receive a rate equal to or greater than the fed funds rate like institutional investors do. Check your brokerage firm’s policy!
Fails are the other source of income for a stock-loan department. Fails occur when borrowers fail to return the stock on time. The revenue is produced by the discontinued payment of rebate interest on a failed stock return. These are not a major concern for small retail borrowers due to the fact they will either be bought-in and or not paid a rebate in the first place. It may seem insignificant but the interest on 100 million dollars is $11.111.11 Per/day at 4% the current fed funds rate. It is not uncommon for repo desks to lend out billions of dollars on a daily basis. The fail is stock-loan departments fattest source of revenue putting a premium on a smooth and efficient wire room to minimize in house fails.
If you run a repo-desk on the street and tried to raise cash through securities lending, collateral would be 102, 105 or even as much as 110% of the cash and approved securities with rights of substitution and repriceings options. The difference in cash verses collateral is referred to as the rebate haircut. The only point here is to point out haircuts, repricings and rights of substitution act as risk management tools for stock-loan departments and their counter-parties.
