Tuesday, June 17, 2014

Why Short-Selling?

In reference to my recent posts on the dueling MLM moguls and their diversity minions, I have a question:  how does short selling work?

I know the textbook answer:  short-selling means “borrowing” stock and selling it, hoping the price goes down so it can be re-purchased at a lower price and returned to its owner.  But . . . what does it mean to “borrow” a stock?  Or more precisely, why would anyone “lend” me their stock?  I assume the lender charges some kind of rent for his loaned stock and a fixed lease time, but is that correct?  And why would I be enthusiastic about lending stock to someone so he can “bet” on a price decrease?  Especially (as in this case) when the short-seller is politically connected, and might be able to drive the price down irrespective of the stock’s value fundamentals, during which time I can’t sell it myself because I’ve loaned it out!

And why, as a regulatory matter, do we allow short-selling in the first place.  I get that, in theory at least, speculators aid in price discovery.  But short-selling is something beyond that, and it’s not really clear how it adds value to the market.

I would be grateful to anyone who can answer these questions.

10 comments:

newrebeluniv said...

It doesn't make much sense to me either. Is there a pool of stocks somewhere that contains stock available for short sale?

trumwill said...

I don't know the logistics very well of how it works, but my understanding is that the price determination aspect is really important to markets. Allowing people to hedge against a company, instead of just for it, gives investors and the economy a better idea of problems looming on the horizon. I think it's mostly a check on unchecked optimism. Having people betting for something, and nobody betting against it, can skew expectations.

Something along those lines.

newrebeluniv said...

But the stock market is not supposed to be "betting". obviously, it is for a lot of people. Business insiders understand their businesses in much greater detail than any of us can hope to know. Even something simple like major company execs dumping shares would go un-noticed by most of us until it is too late. We would most likely be the ones whose funds are still buying during the sell-offs and helping the execs retire comfortably on money we were saving for our own retirements. This is a twisted system that has very little to do with capitalism or free markets.

trumwill said...

How is the stock market not a bet that a company will increase in value? Investment is gambling, of a sort, and it's a sort of gambling we want.

There are exceptions such as if you're trying to get a controlling interest because you think you can direct the company better than the current lot (that's at least gambling on your own abilities to produce), or if it's something you genuinely believe in for social reasons, but those are exceptions.

Against that, you have futures, mutual funds, and all sorts of other things. I think there is a visceral skepticism of short-selling as something bad because you're betting on something bad happening. But I was convinced otherwise by Vikram Bath (whom Phi may remember under a different name).

You're right that a lot of people don't know there is a problem until there's too late. Short sellers do provide an indication, though.

Dr. Φ said...

Re: Vikram. Can I guess? Did his former pseudonym begin with "B"? I always wondered what happened to that guy.

So, basically, short-selling creates a direct method to profit from either genuine pessimism or from taking a public position against a stock, and this is necessary to counter either genuine optimism or taking a public position in favor of a company. That doesn't sound unreasonable.

I'd still like to understand the mechanics better, though.

newt0311 said...
This comment has been removed by the author.
newt0311 said...

My background is mostly in fixed income, not equities so I'll probably miss a bunch of the details but here goes...
(I'll fill in corresponding details for bonds though.)

What does it mean to borrow a stock?

Pretty much literally what it sounds like. An investor (hedge fund/mutual fund/individual investor) goes to "somebody" and gets them to lend the stock to them for a price. The price is akin to the interest you would have to pay for borrowing cash from a bank and depends on the security the investor is trying to borrow, how good a client the investor is, whether the lender is axe'd to lend that security, etc...

The "somebody" depends on who is doing the borrowing. Hedge funds and other professional investors generally borrow from their prime broker (the entity responsible for clearing and warehousing their various positions). Most of the major banks (GS, JP, Citi, Morgan Stanley, etc...) have prime brokerage divisions*. Individual investors can generally borrow from their brokers (Fidelity, Scottrade, etc...). There are also inter-dealer borrow markets.

The technical contracts used to effect the borrowing vary. In FI, repo is the most common way of borrowing securities (search for "specials repo") but repo can also be used for equity & commodity assets**. In a repo contract, the cash lender buys securities from the securities lender with an agreement to sell the securities back at a fixed price. Essentially it is a collateralized loan. For equities, I think securities lending agreements are more common but the economics of both of these are very similar.

Why would anybody lend stock?

Rent.

But what if the lender wants to sell?

Loaning a stock generally doesn't affect ones ability to sell it because (a) most such agreements are overnight anyway, and (b) they can arrange to borrow the security from some other source. Have to be careful here about bid-offer of course.

Ultimately, there are a net positive amount of stocks in the market so somebody has to own them. That somebody (or their prime broker) may as well lend them out and earn a little extra carry in the process.

For fixed income securities, especially short dated ones (<1.5 yrs to maturity), the carry from repo can be the dominant PnL driver because the inventory can be used for cheap cash for other activities. 3m USD LIBOR is currently around 20-30 bps (and most people can't borrow at LIBOR). Overnight repo on high-grade collateral is available for ~10-15 bps for a buy-side investor and considerably lower (single-digit bps and below) for dealers because dealers can sit on the other side of the bid-offer spread.

Especially in fixed income, it is very common to use inventory as collateral to build up leverage. A prime example are mREITs (AGNC, NLY, etc...) which buy agency backed mortgage securities and repo them out to build up leverage (anywhere from 5:1 to 9:1 leverage ratios) so there the securities lending is more a side-effect of the investment strategy.

One point worth mentioning is that all these lending contracts are collateralized and margined (usually daily). They also have attached haircuts if one side has shaky credit or the collateral happens to be volatile. Nobody wants to take credit risk when lending securities.

* Prime Brokerage divisions are generally walled off from the rest of the firm to protect the clients of course.

** Non-high grade securities generally go through a system known as "Tri-party repo". The details are orthogonal to this discussion so I'll leave them out here.

newrebeluniv said...

Trumwill, I don't think you understand the basics about risk, investing under risk, and gambling. The person selling you stock as a broker is not risking anything or gambling. He is making money on every transaction. The company executive who knows his company is going under because he has no cash reserves to make payroll is not gambling when he sells his stock. He has an asset.

The only mitigation for this system is that you can't be cheated if you don't play. (unless your government taxes you to help cover the losses of the gamblers).

trumwill said...

NRU, You being up a good exception to add to the ones I brought up, but by and large those are the exceptions. I consider most investing to be people buying and selling stock in Apple, mutual funds, and so on. Putting your money with a company that's likely to increase in value. Like putting your money on a football team you think is likely to win, or a horse. Or a number on a roulette wheel.

I should also note that as I understand it, a company executive can't just sell his stocks willy-nilly. He has to announce ahead of time that he will be doing so, in part so that company insiders don't have too great an information disparity with other investors. It is assumed that most investors don't have the sort of information that an executive does.

heresolong said...

Perhaps, as a regulatory matter, the government shouldn't be involved in regulating mutually agreeable exchanges in a free market. Then the issue is moot other than the curiosity portion about the mechanics of short selling.