As markets fall, stock lending keeps on truckin’

15 July 2008

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)? 

Not so.  We reported some data from Goldman Sachs last fall that suggested the smaller supply of Russell 2000 stocks had led to an increase in borrow fees during 2007.  But many experts felt at that time that the huge supply of lendable large cap stocks would keep borrow costs under control.

But now we’re starting to see evidence that even large cap borrows might actually be in short supply.  The Independent reported yesterday that the average borrow fee for a blue-chip security has doubled in the past 10 months on both sides of the Atlantic.  But it gets worse.  The paper says the fee to borrow a mid-cap (FTSE 250) name has tripled during the same time period. 

How low will markets have to go to remove some of the enthusiasm for shorting (and with it, some of the froth from borrow demand)?  That’s anyone’s guess.  But for the time being, the pension funds and other long-term investors who lend out their stock are helping the prime brokerages shovel the cash into the truck.   

Addendum: While the Independent says there is “no market” for shorting, there are some emerging business models that may eventually bring some sanity to the borrow market.  One is the recently-launched Lendex that allows lenders to side-step prime brokerages and list their lendable stocks themselves.

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One Response to “As markets fall, stock lending keeps on truckin’”

1. Alex Says:
   July 21st, 2008 at 9:00 am

   Another soon to be launched business model is Quadriserv.