Short selling: Who lends you the stock?

Everybody is talking about short sales this week. Everybody knows, or at least they know now, that “A short sale is the sale of an asset or stock the seller does not own. It is generally a transaction in which an investor sells borrowed securities in anticipation of a price decline; the seller is then required to return an equal number of shares at some point in the future.”

But who would lend you stock? Nobody ever asked me if they could borrow stock. And what’s in it for the lender?

As I understand it, if you have a margin account with a broker, usually because you want to borrow on margin but also if you want to write options or sell stocks short yourself, the broker is allowed to lend out any stock you own. It’s part of the agreement with the broker that allows you access to the services requiring margin.

But that’s only what I’ve heard said elsewhere, and only in response to recent events.

As to what’s in it for the lender in general - interest (which might be called rent). Short positions cost money to keep open. The broker is taking a risk when they allow you to short, as prices might tumble out of control and leave you unable to cover.

Almost always it is the broker doing the lending and it is the broker who is on the hook for it.

So, let’s say you and 999 other people use Broker-A to buy and sell shares.

Maybe 100 of you own stock-A and, collectively, own 1000 shares of stock-A.

The broker may loan out some of that stock. It is not from “your” account. It is from the pool of 1000 shares. When the broker makes this loan they get a fee for that loan. It does not matter if the stock goes up or down. The broker collects that fee.

You and the other shareholders do not benefit. You never see a dime of that money.

It’s like a bank making loans. They use your money to make loans but you do not benefit from it.

I should add…

Let’s say you are the only person who owns 1000 shares in stock-A and your broker has loaned them out. Your broker did not tell you or ask you and you are not benefiting from it.

However, if you tell your broker to sell some of your shares then your broker needs to make good on that order (usually by buying them on the open market). That is the risk the broker takes when doing this.

Usually, with a large pool and a lot of people owning stock-A it is not a problem since they should always have some in reserve for such occurrences. But it can be a problem if the market turns hard and everyone calls them and tells them to sell their shares at the same(ish) time.

This is a cite for the fact that brokers cannot lend out shares in a non-margin account. If you hold shares in a margin account, you’re liable for some of your dividends to become non-qualified since they aren’t actually dividends but payments made in lieu of dividends.

So how is it possible that, in the case of Gamestop, there were more shares borrowed and shorted than actually existed on the market? I assume that the broker can lend the same batch of shares to as many people as he likes?

This article seems to say (I’m far from an expert) that it’s not from the same broker lending out the same shares, but the same share being lent out by a “string” of brokers:

Broker B borrows shares from Broker A, and then Broker C borrows those “same” shares from Broker B. Those shares have now been loaned out twice and therefore “contribute” twice to the number (and percent) of shares loaned.

I think it’s a bit different. What it is, is a string of sellers, who may or may not have different brokers.

Meaning Joe owns some shares, with Broker A. Bob (who also has an account with Broker A) sells them short, so Broker A lends the shares to Bob, who sells them to Alice. At that point someone else who shares the same broker as Alice (which may or may not be Broker A) decides to sell short, and that broker borrows Alice’s shares and sells them to Vanessa. So the same shares have been sold short twice, each time being borrowed from the latest buyer.

Agreed that a share can be lent more than once. Not by the same person, but by successive people in the chain.

A owns a stock. His broker lends it out, B borrows it to sell short to C. Now C owns it, and his broker lends it out to D… rinse and repeat.

One answer to the OP’s question is index funds lend out lots of shares. Lots and lots of stocks are held by large institutional investors that buy everything for a big fund. Those institutional investors lend out their shares and use the income to offer really low fees to people who want to own the index.

When I worked on the institutional sales desk at UBS Tokyo and Hong Kong in the 1990’s. Shares were borrowed from a number of sources. Ultimately, the real source of stock for short sales came from the big fund management companies like Fidelity.

Dealers and brokers were a lot less reliable. “Loaning” stocks they didn’t have in the short term.

What happened with GameStop was a not unusal occurance in the Tokyo and Hong Kong warrants market. Whereby the shorts exceeded the free float or the actual stocks available for sale. Hence, short squeeze. You’re short and desperately trying to find some underlying stock before getting fired and/or losing a shitload of money.

Without having watched this closely, I’d say GameStop was a pretty unique event. A bunch of short sellers came up against an unexpected 800 pound gorilla that took them to the cleaners.

No single player or small group can match when the entire market aligns against them. Just ask the Bank of England. The only possible exception is the US Government, who is the 10,000 pound gorilla in the currency and bond markets, and have fiat money.

The one thing I do not understand is that the short sellers believed the company was going out of business. If this is true, then why couldn’t the short sellers have just hung in there until it did?

Two reasons. One, there are probably terms that say if the stock goes high enough you have to put more money up as collateral, but who knows what the contract looks like for the hedge funds. You or me would have been asked to put up way more than we had shorted the stock for long ago if we wanted to hang in there.

Two, and this affects everyone, you have to pay interest on the share price of the stock you’re borrowing, since you’re not borrowing the money, you’re borrowing the stock. If it’s 10% interest, and the stock goes up by 3000%, you’ll be paying 300% yearly interest just to keep your position to stay.

This is probably the main reason. And the problem is that it’s not just the amount they had to put up when the stock hit $250 or $350 or wherever it was that they covered. An even bigger problem is the prospect that it would go up further, to some other even more ridiculous number.

Once the stock was hitting levels that had no connection whatsoever to the fundamental value, then all bets were off. If it could go to $350, then what’s to say it can’t go to $1,000 based on the same dynamic which pushed it to $350? No way to know.

So if you’re a hedge fund who shorted an enormous amount at $15, and now you need an enormous amount of collateral because it’s at $350 (or whatever), then your problem is that even if you have the money now, you might not have enough to back your position if it fluctuates up to $1,000 (or whatever), and then you would be forced into covering at even higher levels. So you might be inclined to take your losses and cover now, rather than face the prospect of taking even bigger losses and being forced to cover later.

This all applies even if you’re 100% confident that one month, two months from now, the stock will be back in the $15 range.

But if they only need to put the money up to meet collateral requirements why can’t they do that and ride the stock back down to $15?

Sure, they will have a lot of money tied-up but it’s not “lost” either.

Either they don’t have that much money now, or they’re afraid they won’t have that much money later. This is billions of dollars that we’re talking about.

As has been said, the stock is lent by a brokerage house that is long the stock. To further complicate things, you don’t actually have to borrow the stock before you sell it short. Rather, you just have to secure a “locate” on the shares. A locate is essentially documentation that a short seller has a reasonable expectation that shares will be available to find and deliver when the trade settles T+2 days after the trade is made. In the event a short seller’s locate doesn’t come through, it could lead to a “failure to deliver.” In this case, the short seller’s brokerage will typically send angry emails/phone calls to the short seller either demanding they locate additional shares or buy back and close the short position in the market. Otherwise, the broker will take the trade into their own hands and buy the position in themselves to both avoid regulatory issues and monetary issues (if the short seller’s loss exceeds their balance).

This leads to two different situations that are both referred to as a “short squeeze.” One, where the short seller is forcefully bought in by their broker due to mechanical failures of the stock borrow plumbing. The other is short sellers panic-buying stock because the price is going up and they are losing money and want the pain to stop.

Not necessarily. They merely expect the price of the stock to drop enough while they own it to make a profit shorting it.

For example, a few years ago, GE stock was in the mid-20s. It’s currently at 11. If you thought GE was going to drop (there was news that it was going to suffer major losses, which led to the price drop), you could have shorted it, but the company is still in business and is slowly recovering.

I listened to an NPR podcast that discussed the whole GameStop thing. This is a little off from my OP but interesting. Many of the people who wanted to drive the price up where not actually buying the stock, they were buying call options. Apparently this often causes the seller of the call to buy the stock in case the option is exercised. The call buyer never has to actually buy the stock but can indirectly increase demand causing the price to rise, at a small cost and no downside risk.

Ah - great post and I tried to ask on Reddit but must have had the wrong board.

Warrants/options are a completely different thing because they are a promise to either call (buy) at a price or push (sell) at a price in the future.

A seller of an option will also buy some calls just in case they get caught out. That is cover. Doing this enough generates tiny amounts of money but when banks and funds do it all day every day it becomes real money.

As I understand it, no shares are actually bought, one side pays the other on the due date.