exists to match these short sellers with owners of the stock willing to
lend their shares for a fee. The equity lending market’s importance is
emphasized by its size: securities loans in the United States are estimated
to be worth $700 billion.
Despite its obvious importance to the operation of financial markets,
the equity lending market is arcane. The market is dominated by loans
negotiated over the phone between borrowers and lenders. Although there
have been significant improvements in recent years, there is no widely
used electronic quote or trade network in the equity lending market.
THE LENDING PROCESS
An investor who wants to sell a stock short must first find a party willing
to lend the shares.2 Once a lender has been located and the shares are
sold short, exchange procedures generally require that the short-seller
deliver shares to the buyer on the third day after the transaction (t + 3)
and post an initial margin requirement at its brokerage firm. Under Regulation
T, the initial margin requirement is 50%. Self-regulatory organizations
(e.g., NYSE and NASD) require the short seller to maintain a
margin of at least 30% of the market value of the short position as the
market price fluctuates.
As described in Exhibit 2.1, the proceeds from the short sale are
deposited with the lender of the stock. For U.S. stocks, the lender
requires 102% of the value of the loan in collateral. The value of the
loan is marked to market daily; an increase in the stock price will result
in the lender requiring additional collateral for the loan, and a decrease
in the stock price will result in the lender returning some of the collateral
to the borrower. When the borrower returns the shares to the
lender, the collateral will be returned.
While a stock is on loan, the lender invests the collateral and
receives interest on this investment. Generally, the lender returns part of
the interest to the borrower in the form of a negotiated rebate rate.
Therefore, rather than fees, the primary cost to the borrower is the difference
between the current market interest rate and the rebate rate the
lender pays the borrower on the collateral. A lender’s benefit from participating
in this market is the ability to earn the spread between these
rates. Although the earnings from this interest spread are often split
between several parties participating in the lending process, the interest
can add low risk return to a lender’s portfolio.
Read More : Mechanics of the Equity Lending Market
