Economy of Stock Shorting
In my earlier article, I discussed how stock shorting works in the equity world by facilitating liquidity. In this article, I will analyze in detail the interests and money flow of stock shorting.
Stocks vs Contracts
Comparing with derivatives or futures contracts, stock shorting seems more mysterious. For a contract, shorting is always symmetric to buying (or longing) because a contract always has two sides when it is established: the buy side and the sell side. Thus there is no special rules against shorting versus longing. Then why stocks are different? We have Regulation SHO from SEC on "failure to deliver" which is mostly applicable to short stocks. The brokers have "hard-to-borrow" list to warn investors of shorting certain stocks, and we have non-shortable list that simply disallows investors to short certain stocks altogether.
The reason is a stock is considered as an equity, not a contract. Even though each trade is made of buy side and sell side, there is an asset changing hand in the transaction. The natural assumption is the sell side has to have the equity before the transaction, otherwise, it is not a sell, but a "short". Obviously for contracts, there is no such distinction at all. When a contract is opened, selling is exactly like shorting; while an existing opened contract change hand, selling is different from shorting, but it is simply a book keeping notation in regarding to the resulting position of the traders. At the transaction of the contract, there is absolutely no distinction between selling or shorting.
In my view, the argument that stocks are different from contracts is quite arcane, considering how the modern stock market works: when public traded stocks are transacted, there is no longer paper certificates changing hands (unless under the special request from the stock holders). A stock equity is no longer a physical asset, instead, it becomes a "right" to an asset -- exactly the same as a contract. In another word, the modern stock market behaves exactly like contract market for futures and derivatives: they are all trading the rights, or a generalized form of contracts, rather than actual paper certificates. Thus in theory, stock trading should be exactly the same as contract trading: there shouldn't have a distinction between "short" and "sell".
We are not going to further discuss in this article the rationality of whether equity is different than contracts, instead we take whatever in the current reality -- the regulatory restriction around stock shorting, and we will analyze how exactly it works in the money flow, so that we can understand all parties involved in the process, who takes risk, who provide the facilitaty and liquidity.
Moneyflow in a Stock Sale
Supposed "A" sells 1000 shares of a stock to "B" at the price of $20, through broker X (commission: $10). Here is the money flow of this transaction:
- "A" will take in cash of $20000 - $10 = $19990. This cash will accrue interests, supposedly at the interest rate of 4% (typically below the common market borrowing rate, say 5%).
- "B" has to put up cash $20000+$10 = $20010 for the purchase. The cash will be borrowed from the broker, thus being charge at 5%. B is now a stock holder.
- "X" will take in $20 for commission, plus 5% on $20010 less 4% on $19990. He only needs to finance the difference of $20 between the loan and deposit.
In this picture, the sole risk taker is B. If the stock he is holding appreciates in equity market value more than 5% of the financing rate, he has a good trade. Otherwise, he is losing money -- even if the equity price is unchanged, or appreciates slowly (say, 2%), he would still loss money. How about "B" does not borrow money from the broker to finance the trade? The above conclusion is still the same -- because the cash he uses for the stock purchase is now deprived of the interest earning power as a deposit, thus the equity appreciation still have to be at least 5% for this trade to break even.
Broker "X" does not take market risk (but takes credit risk), and he earns his risk-free money as fees and interest spread because he provides liquidity and financing facilities to make this transaction possible. It is worth noting that in the long run, the interest spreads the brokers earn (for provide financing) may well surpass the commissions earned (for provide liquidity). For example, in the above example, the interest spread the broker earns is $200/year.
Moneyflow in A Short Sale
How would short selling be different from the above process? Supposed "A" wants to sell short the stock. He shorts 1000 shares at $20 to "B" (who will buy 1000 shares). Here is what will happen before the settlement (Within 3 trading days, or T+3 rule): Broker X will have to locate the shares to borrow for A to sell short (while for B, he has no idea whether he buys the shares from someone who shorts, or some who sells an existing holding). Supposed "X" borrows it from "C", another stock holder depositing his shares with Broker Y. To facilitate the borrowing, Broker X has to put up the collateral of the cash value of the current stock value (actually the collateral amount should be slightly higher than the actual cash amount, but for the sake of simplicity, I assume they are the same). The collateral cash will be transferred to Broker Y, who would deposit it for interests. However, the typical borrowing contracts require Y to rebate most part of interests back to X (which make sense -- after all, the cashcomes from the proceeds of "A"'s short selling), unless the stock is very scarce or "hard-to-borrow", in which Y can demand to rebate a smaller portion, or none, back to X. In some extreme (but no uncommon) cases, not only Y does not rebate back to X, he may even request X to pay him a premium for the borrowing.
Let's consider the typical case: Y rebates most of the interests of collateral back to X. What happen to these rebate dollars? Does Broker X gives it back to customer "A", who generates a cash deposit from the proceeds of the short sale (such cash deposit makes up the collateral for the stock borrowing)? That depends on the brokers. For individual investors, because of the cost in the operation of borrowing, Broker X may not pay much to "A" at all. For broker/dealers or big funds who would negotiate with the broker, "X" will pay most part of the rebate back to "A". Thus the interest rate for the short stock proceeds is called "short rebate rate".
The moneyflow looks like this:
- "A" will take in cash of $20000-$10 = $19990. The cash will be deposited but not earning the typical deposit interests, instead it will earning short rebate rate, say it is 3.5%. Now "A" is holding a short position.
- "B" will use $20010 cash to buy the stock from "A" and will be charged for 5% interests for the borrowed cash. "B" is the stock holder.
- "X" will take in $20 commission, charge "B" 5% for $20010, pay 3.5% rebate rate to "A" for $19990. "X" will forward $20000 (the cash from "A"'s short sell) to Y as collateral for stock borroowing, while receiving 4.0% from Y as the rebate.
- "Y" will take $20000 cash from X as collateral, deposit in the bank to earn 5% interests income, but pay 4% back to X as rebate. Y will take the shares from one or multiple investors' stock deposit and lend them to X. Supposed this stock holder is "C". Does he knows about his shares are being lent out? Unlikely, unless he requests a stock certificate.
- "C" is still a stock holder, even though his 1000 shares are lent out to "A" (facilitated through brokers X and Y) to sell to "B".
Now we have two stock holders "B" and "C", each has 1000 shares, and A has a short position of 1000 shares.
When the company issues dividends, B and C both expect to receive dividends, one will get the cash from the company, another will get the cash from "A", the short position holder. However, for A, even though he has to pay out dividends, there is no loss to him no matter what amount the dividend is, because on the ExDiv date, the stock price will drop exactly the dividend amount, thus the dividend distribution will not incur any gain or loss for A or B or C.
A, B and C are all taking risks. Their gain or loss in equity value are subjected to equity price movements. For B and C (stock holders), the equity price should appreciate faster than interest rate (5%) for them to be profitable. For "A", equity price should not appreciate faster than 3.5% to avoid loss.
Does Broker Y pays "C" any portion of the 1% interests he retains (5% deposit less 4% rebate to X) to "C"? Not necessary, unless C is a major investor and have agreement with the broker regarding stock lending -- as an individual investor, I have never seen a penny from my brokers for stock lending. Supposedly "C" is a big fund manager and he gets Broker "Y" to pay him half of whatever interest income after rebate. Now a simple short stock transaction creates 3 additional risk free net gainers: Broker X (net gain 0.5%), Broker Y (net gain 0.5%) and C (net gain 0.5%). The origin of such gains come from the cash proceeds of "A"'s short sell, which in theory should have a money growth rate of 5%, nevertheless, "A" receives only 3.5%, while the rest is distributed to other parties along the process.
It is worth noting that if both A and C are individual investors, "A" may receive much lower rebate rate for the cash, say 2%, while C never gets anything from his broker (and never know whether his shares are lent out or not). The interest spread of 3% (5% - 2%) is earned by the intermediaries, Broker X and Y.
Negative Short Rates
The above example illustrates the complexity of stock shorting. Brokers have to locate and borrow shares, arrange collaterals for the borrowing, negotiate rebate rates, and have to do the necessary book keeping to separate out the cash proceeds from the rest of "normal" cash. Such complexity can have some negative effect on the market liquidity. One common side effect is the negative rebate rates.
It is not uncommon to see a stock having negative rebate rates for a certain period of time. For example, GM (-20% in the mid 2006 when the stock tanked with all the talks about potential bankruptcy); ALD (a perpetual negative rebate rate name due to constant battle between major shareholders and short sellers); NYX (-12% in December 2006).
Negative rebate rates arise from the situation when the stocks become very hard to borrow. In that case, the stock holders (actually it is most likely the brokers who have the stocks in their custody) can demand that not only they will not give rebate of the collateral, they demand the borrower to pay more to borrow shares. If that happens, "A" will have to pay interests (instead of collecting interests), and the net proceeds from "A"'s interest payments, in addition to deposit interest income from his cash as collateral, will be distributed among the 3 parties (Broker X, Y and possibly stock holder "C").
If the stock holders can demand a special rebate or even negative rebate, why not everyone does so? In the end, supply/demand and competition in the market will come into working and pull this back in balance. If one shareholder makes special demands, while others simply follow the norm, the special demands will end up useless because no one will borrow from that shareholder. Obviously if the shares of a particular stock is concentrate in a few big holders, they can exert power to see special demands get implemented and the ability to short stock become skewed.
Contract Market Can, Why Can't Stock Market?
Are all these complexities necessary? In the contract world, where short and long are absolutely symmetric, there is none of these complexities -- no special requirement for locating and arranging shares to borrow before settlements, thus there is no place for the collateral deposit and rebate, and certainly no place any stock holders to make special demands for rebates, which in the cases of high concentration of shares in a few share holder's hand, can amount to extortion and impediment to market liquidity.
How can contract market rid of these nuisances and still functions well? The magic lies in a simple concept called "fungibility". It says that any contracts of the same type publicly traded on exchanges are equivalent after settlements, no matter who are the counterparties of the trades. For example, if someone wants to sell a contract, if he can open a new contract, or he can sell existing one. The two cases do not make any difference because at the end of the day at settlement, any long or short positions of the same type under a holder will netted out. There is no need for the "borrowing" process.
It is really simple, isn't it? And it should be this way. In the stock world, the special borrowing process actually make stock non-fungibile: shares owned by certain shareholder can make demand for special rebate rate, thus causing the ridiculous situation that same stock can have different kinds of rebate rate on different brokers.
The power of fungibility allows contract market to achieve two things that the much older stock market cannot achieve: 1) One day settlement (stock settlements take 3 days, even in the modern day that all trading are powered by computers); 2) No special rules for shorting, thus no complexity in the special rebate rates.
In my view, all these complexities and inefficiencies derive from the historical limitation that stocks come as a tangible asset as paper certificates. In the modern market, we should abandon the arcane view that stock is a special physical equity, and adopt the view that stocks represent rights just like contracts, we can then throw all these regulations as well as the paranoids regarding shorting stocks out of window. The contract markets show that a symmetric long/short market can function well and healthy.
(The author can be contacted at huangxinw@gmail.com.)
Stocks vs Contracts
Comparing with derivatives or futures contracts, stock shorting seems more mysterious. For a contract, shorting is always symmetric to buying (or longing) because a contract always has two sides when it is established: the buy side and the sell side. Thus there is no special rules against shorting versus longing. Then why stocks are different? We have Regulation SHO from SEC on "failure to deliver" which is mostly applicable to short stocks. The brokers have "hard-to-borrow" list to warn investors of shorting certain stocks, and we have non-shortable list that simply disallows investors to short certain stocks altogether.
The reason is a stock is considered as an equity, not a contract. Even though each trade is made of buy side and sell side, there is an asset changing hand in the transaction. The natural assumption is the sell side has to have the equity before the transaction, otherwise, it is not a sell, but a "short". Obviously for contracts, there is no such distinction at all. When a contract is opened, selling is exactly like shorting; while an existing opened contract change hand, selling is different from shorting, but it is simply a book keeping notation in regarding to the resulting position of the traders. At the transaction of the contract, there is absolutely no distinction between selling or shorting.
In my view, the argument that stocks are different from contracts is quite arcane, considering how the modern stock market works: when public traded stocks are transacted, there is no longer paper certificates changing hands (unless under the special request from the stock holders). A stock equity is no longer a physical asset, instead, it becomes a "right" to an asset -- exactly the same as a contract. In another word, the modern stock market behaves exactly like contract market for futures and derivatives: they are all trading the rights, or a generalized form of contracts, rather than actual paper certificates. Thus in theory, stock trading should be exactly the same as contract trading: there shouldn't have a distinction between "short" and "sell".
We are not going to further discuss in this article the rationality of whether equity is different than contracts, instead we take whatever in the current reality -- the regulatory restriction around stock shorting, and we will analyze how exactly it works in the money flow, so that we can understand all parties involved in the process, who takes risk, who provide the facilitaty and liquidity.
Moneyflow in a Stock Sale
Supposed "A" sells 1000 shares of a stock to "B" at the price of $20, through broker X (commission: $10). Here is the money flow of this transaction:
- "A" will take in cash of $20000 - $10 = $19990. This cash will accrue interests, supposedly at the interest rate of 4% (typically below the common market borrowing rate, say 5%).
- "B" has to put up cash $20000+$10 = $20010 for the purchase. The cash will be borrowed from the broker, thus being charge at 5%. B is now a stock holder.
- "X" will take in $20 for commission, plus 5% on $20010 less 4% on $19990. He only needs to finance the difference of $20 between the loan and deposit.
In this picture, the sole risk taker is B. If the stock he is holding appreciates in equity market value more than 5% of the financing rate, he has a good trade. Otherwise, he is losing money -- even if the equity price is unchanged, or appreciates slowly (say, 2%), he would still loss money. How about "B" does not borrow money from the broker to finance the trade? The above conclusion is still the same -- because the cash he uses for the stock purchase is now deprived of the interest earning power as a deposit, thus the equity appreciation still have to be at least 5% for this trade to break even.
Broker "X" does not take market risk (but takes credit risk), and he earns his risk-free money as fees and interest spread because he provides liquidity and financing facilities to make this transaction possible. It is worth noting that in the long run, the interest spreads the brokers earn (for provide financing) may well surpass the commissions earned (for provide liquidity). For example, in the above example, the interest spread the broker earns is $200/year.
Moneyflow in A Short Sale
How would short selling be different from the above process? Supposed "A" wants to sell short the stock. He shorts 1000 shares at $20 to "B" (who will buy 1000 shares). Here is what will happen before the settlement (Within 3 trading days, or T+3 rule): Broker X will have to locate the shares to borrow for A to sell short (while for B, he has no idea whether he buys the shares from someone who shorts, or some who sells an existing holding). Supposed "X" borrows it from "C", another stock holder depositing his shares with Broker Y. To facilitate the borrowing, Broker X has to put up the collateral of the cash value of the current stock value (actually the collateral amount should be slightly higher than the actual cash amount, but for the sake of simplicity, I assume they are the same). The collateral cash will be transferred to Broker Y, who would deposit it for interests. However, the typical borrowing contracts require Y to rebate most part of interests back to X (which make sense -- after all, the cashcomes from the proceeds of "A"'s short selling), unless the stock is very scarce or "hard-to-borrow", in which Y can demand to rebate a smaller portion, or none, back to X. In some extreme (but no uncommon) cases, not only Y does not rebate back to X, he may even request X to pay him a premium for the borrowing.
Let's consider the typical case: Y rebates most of the interests of collateral back to X. What happen to these rebate dollars? Does Broker X gives it back to customer "A", who generates a cash deposit from the proceeds of the short sale (such cash deposit makes up the collateral for the stock borrowing)? That depends on the brokers. For individual investors, because of the cost in the operation of borrowing, Broker X may not pay much to "A" at all. For broker/dealers or big funds who would negotiate with the broker, "X" will pay most part of the rebate back to "A". Thus the interest rate for the short stock proceeds is called "short rebate rate".
The moneyflow looks like this:
- "A" will take in cash of $20000-$10 = $19990. The cash will be deposited but not earning the typical deposit interests, instead it will earning short rebate rate, say it is 3.5%. Now "A" is holding a short position.
- "B" will use $20010 cash to buy the stock from "A" and will be charged for 5% interests for the borrowed cash. "B" is the stock holder.
- "X" will take in $20 commission, charge "B" 5% for $20010, pay 3.5% rebate rate to "A" for $19990. "X" will forward $20000 (the cash from "A"'s short sell) to Y as collateral for stock borroowing, while receiving 4.0% from Y as the rebate.
- "Y" will take $20000 cash from X as collateral, deposit in the bank to earn 5% interests income, but pay 4% back to X as rebate. Y will take the shares from one or multiple investors' stock deposit and lend them to X. Supposed this stock holder is "C". Does he knows about his shares are being lent out? Unlikely, unless he requests a stock certificate.
- "C" is still a stock holder, even though his 1000 shares are lent out to "A" (facilitated through brokers X and Y) to sell to "B".
Now we have two stock holders "B" and "C", each has 1000 shares, and A has a short position of 1000 shares.
When the company issues dividends, B and C both expect to receive dividends, one will get the cash from the company, another will get the cash from "A", the short position holder. However, for A, even though he has to pay out dividends, there is no loss to him no matter what amount the dividend is, because on the ExDiv date, the stock price will drop exactly the dividend amount, thus the dividend distribution will not incur any gain or loss for A or B or C.
A, B and C are all taking risks. Their gain or loss in equity value are subjected to equity price movements. For B and C (stock holders), the equity price should appreciate faster than interest rate (5%) for them to be profitable. For "A", equity price should not appreciate faster than 3.5% to avoid loss.
Does Broker Y pays "C" any portion of the 1% interests he retains (5% deposit less 4% rebate to X) to "C"? Not necessary, unless C is a major investor and have agreement with the broker regarding stock lending -- as an individual investor, I have never seen a penny from my brokers for stock lending. Supposedly "C" is a big fund manager and he gets Broker "Y" to pay him half of whatever interest income after rebate. Now a simple short stock transaction creates 3 additional risk free net gainers: Broker X (net gain 0.5%), Broker Y (net gain 0.5%) and C (net gain 0.5%). The origin of such gains come from the cash proceeds of "A"'s short sell, which in theory should have a money growth rate of 5%, nevertheless, "A" receives only 3.5%, while the rest is distributed to other parties along the process.
It is worth noting that if both A and C are individual investors, "A" may receive much lower rebate rate for the cash, say 2%, while C never gets anything from his broker (and never know whether his shares are lent out or not). The interest spread of 3% (5% - 2%) is earned by the intermediaries, Broker X and Y.
Negative Short Rates
The above example illustrates the complexity of stock shorting. Brokers have to locate and borrow shares, arrange collaterals for the borrowing, negotiate rebate rates, and have to do the necessary book keeping to separate out the cash proceeds from the rest of "normal" cash. Such complexity can have some negative effect on the market liquidity. One common side effect is the negative rebate rates.
It is not uncommon to see a stock having negative rebate rates for a certain period of time. For example, GM (-20% in the mid 2006 when the stock tanked with all the talks about potential bankruptcy); ALD (a perpetual negative rebate rate name due to constant battle between major shareholders and short sellers); NYX (-12% in December 2006).
Negative rebate rates arise from the situation when the stocks become very hard to borrow. In that case, the stock holders (actually it is most likely the brokers who have the stocks in their custody) can demand that not only they will not give rebate of the collateral, they demand the borrower to pay more to borrow shares. If that happens, "A" will have to pay interests (instead of collecting interests), and the net proceeds from "A"'s interest payments, in addition to deposit interest income from his cash as collateral, will be distributed among the 3 parties (Broker X, Y and possibly stock holder "C").
If the stock holders can demand a special rebate or even negative rebate, why not everyone does so? In the end, supply/demand and competition in the market will come into working and pull this back in balance. If one shareholder makes special demands, while others simply follow the norm, the special demands will end up useless because no one will borrow from that shareholder. Obviously if the shares of a particular stock is concentrate in a few big holders, they can exert power to see special demands get implemented and the ability to short stock become skewed.
Contract Market Can, Why Can't Stock Market?
Are all these complexities necessary? In the contract world, where short and long are absolutely symmetric, there is none of these complexities -- no special requirement for locating and arranging shares to borrow before settlements, thus there is no place for the collateral deposit and rebate, and certainly no place any stock holders to make special demands for rebates, which in the cases of high concentration of shares in a few share holder's hand, can amount to extortion and impediment to market liquidity.
How can contract market rid of these nuisances and still functions well? The magic lies in a simple concept called "fungibility". It says that any contracts of the same type publicly traded on exchanges are equivalent after settlements, no matter who are the counterparties of the trades. For example, if someone wants to sell a contract, if he can open a new contract, or he can sell existing one. The two cases do not make any difference because at the end of the day at settlement, any long or short positions of the same type under a holder will netted out. There is no need for the "borrowing" process.
It is really simple, isn't it? And it should be this way. In the stock world, the special borrowing process actually make stock non-fungibile: shares owned by certain shareholder can make demand for special rebate rate, thus causing the ridiculous situation that same stock can have different kinds of rebate rate on different brokers.
The power of fungibility allows contract market to achieve two things that the much older stock market cannot achieve: 1) One day settlement (stock settlements take 3 days, even in the modern day that all trading are powered by computers); 2) No special rules for shorting, thus no complexity in the special rebate rates.
In my view, all these complexities and inefficiencies derive from the historical limitation that stocks come as a tangible asset as paper certificates. In the modern market, we should abandon the arcane view that stock is a special physical equity, and adopt the view that stocks represent rights just like contracts, we can then throw all these regulations as well as the paranoids regarding shorting stocks out of window. The contract markets show that a symmetric long/short market can function well and healthy.
(The author can be contacted at huangxinw@gmail.com.)
© 2006-2009 by Huangxin Wang 王璜鑫
