Stock lending - is it evil and sinful? Wednesday, September 24, 2008
Over lunch today with a friend from City circles, we briefly discussed short selling and he mentioned that Nicola Horlick had once opined from a conference platform that she thought institutional managers that lent stock to facilitate short selling were idiots as why would anyone lend stock to help others drive down the price of their holdings? This sentiment has been repeated many times recently.
One stock lending source is hedge funds! Hedge funds are not necessarily short sellers. Specifically, hedge funds that consider a stock to be undervalued will buy the shares and finance this by immediately lending them out.
For those unfamiliar with stock lending, this is how it works in a traditional form.
- A borrower (e.g., a broker-dealer or bank) negotiates the terms of the loan with the lender to include price, rebate rate and in some cases, duration. This often involves an intermediary/agent acting for the lender.
- The cash collateral is normally delivered at 102-105% of the market value of the stock lent
- Securities are delivered to the borrower upon receipt of collateral.
- The cash collateral received is invested by the lender to generate a return
- A negotiated portion of the cash collateral interest earned on the reinvestment is paid to the borrower as a rebate.
- The remaining portion of the cash collateral interest earned is retained by the lender as a fee [split if a lending agent is involved]
- The market value of the stock lent is priced and marked to market daily to ensure full collateralisation
- Stock is borrowed either for a specific term [overnight, week, month etc] or on open which means for an unspecified period with the option for the lender to recall it
In the long run, the market value of an equity security should not be affected by the lending of that security. Temporary buy / sell imbalances will not affect long term stock prices as they should ultimately return to their fair value - shares trading at a discount will represent a buying opportunity.
I have to readily acknowledge that most fund managers are closely attuned to their short-term performance and so will be concerned about prices, especially around quarter and year ends. Yet, importantly for pension fund trustees, they are looking at long term returns and income from lending has become an intrinsic part of the returns on the assets.
Back in June, the International Securities Lending Association responded to negative press comments about short selling and lending with a concise yet important set of counter-arguments here. The key points were
- Some borrowing takes place in support of hedging activities e.g. when dealer go long in one instrument such as a CFD and hence go short in a related instrument namely shares. This provides liquidity in the market
- Shares can be borrowed to ease settlement problems that would otherwise clog the system up i.e. a failure by a seller to deliver shares on settlement date may otherwise cause subsequent on-deliveries to similarly fail, an issue that stock lending can address
Short sellers have no more influence over share prices than any other traders. If selling pressure caused a share price to fall below what other investors judged to be its fair value, they would buy and the share price would correct. Those who argue that short sellers can drive a share price below its fair value need to explain why other investors do not take that buying opportunity.
It added that short selling is not a one-way bet.
However, a greater authority than I has pronounced on the subject of short selling - The Archbishop of York. Sadly, the poor man is evidently a bit confused on the matter.
"To a bystander like me, those who made £190m deliberately underselling the shares of HBOS, in spite of a very strong capital base, and drove it into the arms of Lloyds TSB, are clearly bank robbers and asset strippers" Dr Sentamu told the annual dinner of the Worshipful Company of International Bankers according to the BBC.
The £190m profit to which he refers was allegedly made by people buying shares, not selling. Moreover, the story was subsequently debunked. Still, it shows the Archbishop must spend his Sabbath reading the Mail on Sunday.