They say that the market for borrowing stocks (to execute short sales) is one of the last great inefficient corners of the financial industry – where participants can simply back their trucks up to the loading dock and use a pitch fork to shovel the cash inside.

In general, stocks are lent out on an ad hoc basis, allowing the lender (or more accurately, the lender’s agent, the prime broker) to set the “borrow fee” in a relative vacuum rather than letting the market dictate it.  The resulting borrow fee is still loosely based on the supply and demand for the borrow.  So if everyone wants to short a stock, then the demand will increase and the fee will rise.

The possibility of a looming “shortage of shorts” has been bouncing around for some (see, for example, our posting “A Shortage of Shorts?” from November 2007).

You’d think that a demand-driven increase in borrow fee would be accompanied by a commensurate drop in the price of the stock itself.  After all, if everyone hates the company all of sudden shouldn’t the price fall?  And as the price falls, shouldn’t some of the froth come out of the borrow demand (as marginal investors sense they have missed their chance to board the train)?

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