effectively determines the price of a stock loan. This rate is determined
by supply and demand in the market for borrowing stock. For highly
liquid stocks that are widely held by institutional lenders, the borrower
can expect to earn the full rebate or general collateral rate, on the collateral.
This rate is generally 5 to 25 basis points below the Fed funds
rate for each day.9 When there is less available supply in the equity lending
market, as with middle-capitalization stocks, the spread generally
increases to around 35 basis points.
The majority of loans in the equity lending market are made in
widely held stocks that are cheap to borrow. However, on less widely
held securities or securities with large borrowing demand, rebate rates
may be reduced, in which case, the securities are said to be “trading special”
or just “special.” This means that the rebate rate is negotiated on a
case by case basis, and the rate earned by the borrower on the collateral
is below the general collateral rate paid on easily available securities.
Only a few stocks are on special each day; a one-year sample in one
study had approximately 7% of its securities on special.11 And, the specials
aren’t necessarily limited to small stocks; 2.77% of large stocks
were found to be on special in the same sample. In rare cases, when a
stock is in high demand, the rebate rate can be significantly negative.
For example, shares of Stratos Lightwave, Inc. had a rebate rate more
than 4,000 basis points below the general collateral rate in late August
2000, just after the firm’s initial public offering. In these cases, the
lender is keeping the full investment rate of return on the collateral and
also earning a premium for lending the securities.
Although specials are identified by their low rebate rates, the difficulty
of borrowing specials goes beyond the increase in borrowing costs.
Only well-placed investors (e.g., hedge funds) will be able to borrow
specials and receive the reduced rebate. Generally, brokers will not borrow
special shares on behalf of small investors; the order to short sell
will be denied. Loans in stock specials will be expensive for well-placed
investors and impossible to obtain for retail investors.
Specials tend to be driven by episodic corporate events that increase
the demand for stock loans or reduce the supply of stocks available for
loan. For example, initial public offerings, dividend reinvestment discount
programs, and dividend payments of foreign companies often lead
to an increase in borrowing demand and/or a reduction in the supply of
available shares. In the case of IPOs, even though shares are available in
the first settlement days, they are generally on special. At issuance, the
average IPO’s rebate rate is 300 basis points below the general collateral
rate, but this spread from the general collateral rate falls to 150 basis
points within the first 25 trading days. Similarly, the short selling of
merger acquirers’ stock drives specialness. Loans of merger acquirers’
stock have average rebate rates 23 basis points below general collateral
rates.14 Additionally, because brokers prohibit their clients from buying
stocks with prices below $5 on margin, there can be a limited supply of
stock available for loan from broker dealers for these low-price
shares.15 Some factors that can improve liquidity in a stock and therefore
improve its rebate rate include a secondary issue of the security, an
expiration of an IPO lock-up period, and the reduction in short-selling
demand as a result of the completion of a merger or corporate action.
Read More : THE DETERMINANTS OF REBATE RATES
