Sometimes the simplest questions have the most difficult answers. Last week, as GameStop (GME) was at the height of its imponderable surge, a reporter asked me why Bloomberg showed that the short interest of GME was 144% of the float. Her company was not in the business of displaying erroneous data, especially when it came from an external source, yet that reading seemed illogical if not impossible. Rather than make up an explanation that could embarrass both of us, I delved into the mechanics of stock lending. I thought it would be useful to share the explanation with you.
The quick answer is that the same shares can be lent and re-lent multiple times. While the free float – which is defined as the number of a company’s outstanding shares that are available for trading and not held by insiders or the company itself – is relatively fixed, the short interest amount can vary substantially. That number is reported bi-weekly by NYSE and NASDAQ. It is unusual to see such a huge short interest relative to a company’s available shares, but it is not necessarily the sign of something incorrect or nefarious. The full answer is quite a bit more complex.
Stock lending is a crucially important and opaque aspect of the securities industry. Its opacity adds to its profitability, and its profitability is one of the reasons that brokers can offer free commissions. Brokers routinely lend out their customers’ shares, often using the proceeds either as a cheap source of funding or for outright profit. Those lent shares are used by short-sellers. Bear in mind that the vast majority of short-selling is benign, and actually a necessary lubricant to the smooth functioning of markets. Short sales are used by market makers to facilitate customer purchases and for hedging purposes. Arbitrageurs will sell stocks short against index futures or ETFs to keep prices in line. And a wide variety of traders, who legitimately believe that a company is overvalued, will short its shares after borrowing them.
Most holdings fall into the category of “general collateral” (GC, for short), which means that the shares are easy to borrow. A broker will lend those shares and receive money as collateral in return. The borrower of those shares is effectively lending money to the broker in exchange for access to the shares. When the shares are GC, that money is right around the Fed Funds rate. It’s a short-term secured loan with very little risk.
The business gets much more interesting and profitable when shares become hard to borrow. In that case, the borrower of the shares is willing to lend money at a discount in order to get access to the shares. The stock loan for hard to borrow shares is quoted as a negative rate, meaning that the stock borrower will lend money at a negative rate to the stock lender. It is not unusual to see rates of -10%, -25%, or even -100% if a stock is particularly hard to borrow. The short seller is willing to pay to sustain his short and the lending broker is quite pleased to borrow money at a sharply negative rate in exchange.
Borrowing money at a sharply negative rate is such a potentially profitable activity that stock loan departments pay extraordinarily close attention to the availability of hard to borrow shares. They also maintain close links with their counterparts so they can use them as sources or destinations for difficult shares. That is the genesis for the question at hand. A stock lending colleague described it this way:
- A is long 100 shares
- B shorts 100 shares, sells them to C
- B borrows A shares, delivers to C
- D shorts 100 shares, sells to E
- D borrows C shares, delivers to E
- 100 shares initially turns into 300 long, 200 short if the efficiency of borrowing the shares is 100% and the long holders stay long
What we see here is both feasible and legal. Customer B is allowed to sell short as long as he secures a loan from A’s broker. Once customer C’s broker receives delivery from B’s sales, he doesn’t know if those were borrowed or sold outright. C’s broker can then re-lend them to D’s broker so he can sell short. And the chain can theoretically continue.
Sharp-eyed readers can see the risk in this situation. If A sells his shares the chain unravels. Each of the shorts in the chain would have to rely on his clearing broker to find new shares to borrow, otherwise they risk being bought in. That could initiate a short squeeze, and the GME situation shows how powerful those can become.
Short sellers are a curious bunch. They willingly enter a situation with imbalanced risk/reward (stocks can only go to zero but rise infinitely) and pay for the privilege of doing so (via negative stock loan rates). That many of them manage to be consistently profitable is a testament to their courage and careful research. But no one can withstand a tsunami, and with an investor tsunami aimed at short sellers, many find themselves swamped.
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