It’s fair to say that the hedge fund industry as we know it would not exist if it weren’t for one critical, but often ignored function – securities lending.  Like the proverbial swimming duck, a steady flow of stock “borrow” used for short-selling hides the mayhem that goes on just below the waterline.

Through their custodians or on their own, institutional investors often make their holdings available for loan (although some argue that securities lending is not technically a loan).  Doing so routinely produces a small revenue stream with very little risk.  In other words, the closest thing to a free lunch that exists today.  According to the International Security Lending Association (ISLA), there was about $2 trillion worth of securities on loan at the beginning of 2008.

But the credit crunch is starting to eat this free lunch.  Demand has been hit by temporary short-selling bans around the world.  Spooked by what they regard as new counter-party risks, and motivated by a sense of vigilante justice against short sellers, several major institutional investors have unilaterally curtailed their securities lending programs recently.  The head of Citigroup’s securities finance group recently told Global Pensions that:

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