From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
I was one of several people quoted in a recent Global Investor article which looked at the decision by Japan’s Government Pension Investment Fund (GPIF) in December to suspend lending of foreign equities. There have been several articles written on the subject, so I will not revisit those in this post. Instead, I am going to address a question people often ask me and more so since the furor caused by GPIF’s announcement – why do so many different regulators around the world support securities lending and, by inference, short selling?
Obviously, I am not a regulator and don’t speak for any, so these are simply my thoughts and opinions formed over time in discussion and debate with market stakeholders. No doubt some commentators will challenge my assertion that regulators “support” securities lending. Whether they support, accept, tolerate or whichever word one uses to describe their attitudes, it is unquestionably “permitted” in effectively every developed market, many developing markets and even some emerging markets.
This post will focus purely on the benefits to an efficient market, whereas my recent post “Securities Lending – Pennies in front of a steamroller” addressed the considerable revenue contribution that securities lending makes to investors, year in and year out.
I see five different drivers for regulatory permission for securities lending and where relevant, short selling: liquidity, market efficiency, price discovery, a constraint on short selling and market price moderation.
There are two aspects to liquidity for this topic and a related issue I will mention under Price Discovery (arbitrage). Market making would not be possible or at least effective unless market makers have the option to borrow as well as buy securities they have sold to investors. If they were forced to wait until they could purchase securities first, the concept of market making would be undermined as they would not always be able to sell to every willing buyer. The second element is straightforward – by allowing short sellers to participate in a market, there are more trades, both their short sales and their long purchases. It is often overlooked that for every share that is shorted there is a future purchase. Additionally, many proprietary traders that operate market-neutral or hedge strategies will avoid going long in a market if they don’t have an opportunity to short in the same market. More traders, able to trade in either direction, results in more liquidity – providing better conditions for all investors in a market.
One of the original reasons for the development of securities lending was the need to borrow securities to avoid a failed settlement or to remedy a failing trade. This operational imperative reduces the systemic risk that could be caused by failing trades creating an exposure for the buyer against the failing seller as well as the knock-on effect to the wider market where the original purchaser contractually sells the securities that have yet to settle. Trades fail for many different reasons including operational process issues and “naked” short selling.
Naked short sales are transactions where the seller of an asset neither owns it nor made arrangements to borrow it to fulfill the delivery obligations. This poses an obvious settlement issue but additionally could be used in an abusive manner to manipulate asset prices. Most markets now have rules in place that disallow naked short selling, and although there are carve-outs in some markets for some assets and participants, it seems clear that naked short selling no longer has the impact it once had. Given the significant penalties imposed on many market participants for failures to follow the rules around short selling, compliance is high.
The imposition in the US of Rule 204T by the Securities Exchange on October 17, 2008 (just more than a month after the Lehman default) was specifically designed to stop naked short selling as well as clear up a huge backlog of unsettled trades. It required the close-out of failing transactions very quickly after settlement date passed, quickly eliminating the overwhelming majority of failed trades and creating conditions that would prevent a future build-up of fails.
Constraint on Short Selling
One factor that also acts to restrict short selling volumes in most markets is the need for a would-be short seller to ensure that it has a reasonable expectation of being able to borrow the securities prior to executing a short. This “Locate” requirement effectively limits the number of shares available to be shorted. According to a BCG report from July 2019, the global asset management industry had total assets under management of USD 74.3 trillion. The ISLA website shows €21.3 trillion as available for loan, so roughly just over 30% of institutional assets are in lending programmes, so on the face of it, the supply appears plentiful. Let me highlight a few limitations on that headline figure:
€21.3 tn is the total availability, including the reported €2.3 tn already on loan, so not available
The €21.3 tn includes both equities and fixed income. According to the ISLA report from September 2019, equities then represented 67% of the reported availability figure at the time of €19.6 tn. So, if that percentage still applies, then equity supply is more likely in the area of €14.5 tn
The largest values are in main index securities, so the absolute value of availability is skewed towards large cap names, with availability outside primary indices as well as small cap and mid-cap securities less plentiful
Most agent lenders will keep a buffer of between 20% and 50% of holdings to ensure they can meet client sale obligations without having to recall borrowers
Not all agent lenders are contracted with all borrowers nor have all lending clients approved every borrower proposed by agents
In addition to excluding some borrowers, lenders can and do often place limits on individual borrower exposure
Lenders can and do exclude some portfolio assets from lending programmes on an ongoing basis and occasionally when important issues arise.
All these items (and others) means that the true availability of securities for short selling is comparatively low, so the volume of shorting is constrained. Where actual short activity reaches a high penetration of the available supply, short sellers are at increased risk of loss due to short squeezes resulting from sales by one or more large lenders. In fact, a commonly used milestone is that when 20% of the available supply is on loan, red flags start appearing on a short seller’s dashboard. The effect on the market for non-index names is that short selling is practically limited and where utilisation is high, short selling takes on increased risk of loss, moderating activity by some.
Price discovery is the process whereby a current market price for an asset is set. Buyers and sellers consider a wide range of factors including tangible and intangible issues such as supply/demand, investor attitudes, macro and micro issues, literally everything including the human psyche and implicitly or explicitly come to a consensus view that is expressed as the prevailing price. It is neither right nor wrong, it just is. Inevitably some will view that price as expensive, others may consider it cheap, with the remainder having no view or accepting it as a reasonable representation.
I referred earlier to arbitrage whereby a trader will buy and sell equivalent assets with the objective of extracting a profit from temporary mispricing. A straightforward example is the price of a future contract representing an index and the underlying constituents of that index. An arbitrageur would like to see prices move away from the inherent spread differential between a derivative and the physical securities, selling the expensive asset and purchasing the cheap asset. This has a dual impact – clearly it adds to liquidity by generating additional turnover as well as contributing to the return to the expected relative value – which can be considered as contributing to price discovery.
Short selling represents one aspect of that community view of buyers and sellers. Short sellers take positions in securities for numerous reasons and often trade based on relative price movements and therefore are not necessarily dependent on falling prices to generate profits from ideas.
Notwithstanding this, directional short sellers get the media’s attention and do require a price drop to make money so when people think of short selling, this is generally what they have in mind. In reality, dedicated short-only managers represent a very small portion of money in the hands of hedge funds.
The dedicated short seller is research-driven using investigative analysis to identify significantly over-valued companies with a reasonable expectation of a meaningful drop in share price. As with all investing theses, time proves them wrong or right – particularly if they can weather the storm if prices rise rather than fall – sometimes the idea is right, but the timing is too early. For many observers, “too early = wrong”. Importantly, from time to time they uncover corporate malfeasance – companies “cooking the books” or engaging in other misleading or fraudulent behaviour – and expose this to the wider investing community. Examples include Enron, WorldCom, Sino-Forest, to name but a few. To my mind, short sellers are the policemen watching public companies and they provide value that can’t be found elsewhere through uncovering issues often not seen by auditors or regulators.
Can short selling be abused? Of course, but I would argue that abuse can equally occur on the long side and the role of regulators is to establish regulations to curb abuse and monitor the public markets for potential breaches.
Moderating Peaks and Troughs
The final point is a bit of an abstract concept, so bear with me. Most people have heard the phrase “irrational exuberance” used by Alan Greenspan in 1996 to describe unwarranted optimism continuing to drive stock markets beyond their real value, creating the potential for a precipitous drop at some future point when reality reasserts itself. In fact, the dotcom bust stock market fall followed a few years later, proving Greenspan prescient. Markets that overextend themselves eventually run out of steam. Unsurprisingly short sellers were winners at the dawn of this century.
Whenever there is any market crash, investors of all types sell – long investors as well as short sellers. The difference is that short sellers need to repurchase the shorted stocks in order to book profits. Long sellers continue to sell, and we saw that after the short selling bans came into place in the aftermath of Lehman’s default.
So, the effect of short selling at a high level is that it acts to moderate the irrational exuberance at the top of the market by fighting the upward momentum. During a falling market, short sellers participate and increase selling volumes but then become the buyers while others continue to sell. In both extreme circumstances, short sellers have a moderating effect on price movements so that markets don’t fall quite as far as they might otherwise.
You can see this strong inversely correlated relationship in the chart below. Markets that do not allow short selling would likely experience higher highs and lower lows. As I wrote earlier, a little bit abstract, but hopefully the explanation with the chart clarifies the concept.
I think it’s clear that there are positive contributions to the wider markets from getting “better” prices to investors, to assisting the ability of market makers to support markets and providing a safety net against systemic risk. To me, that answers the question: “why do regulators permit securities lending and short selling”.
If you have other views, or wish to share your thoughts, we are always interested in listening.