MECHANICS OF SHORT SELLING-in 700 words!
There appears to be some interest in SM of how short selling works and the mechanics behind it. What follows are my opinions and observations without me ever being a short-seller.
There are a couple of concepts to understand before we commence. One is that someone can sell something they do not own so are effectively short in the market. The other concept is how stocks are housed or owned which leads me to a description of the main players.
Firstly, the long-only fund managers of which there are many. Many decades ago ownership of stocks by the long-only manager was separated so that a custodian was responsible for it. The custodian is contracted by the real owner, the industry fund for example. The LO manager liaises with the broker to put on trades and they liaise with the custodian who moves the ownership of the stock. The important point is LO managers have no control over what can happen to the stock outside of directing through their trades.
The second character is the custodian. These are huge entities, that effectively house the stock and move it with direction from designated brokers and fund managers. The custodian is a responsible entity and controls the ownership and movement of the stocks. These are quite mundane operations and charge a minuscule fee to do this work. The aim is that they are in control of the stock so no broker or fund manager can skedaddle away with the goods.
That is the status quo under usual operations. When a LO manager makes a trade the broker informs the custodian and everyone knows everyone and the stock is moved to a new legal entity, this could be within the same custodian or another depending on the new institutional owner custodial contracts.
Now we bring in the shorters. To short a stock you need something to sell so they would approach the custodians to borrow the stock. However, this is not really the custodians core biz and they do not want to be exposed to credit and reputational risk. Prime brokers were created to manage this task. They are usually owned by investment banks. The prime brokers act as a go-between with the hedge fund shorters on one side and the custodian on the other. Effectively guaranteeing the credit.
Remember the two knuckleheads on “The Big Short” trying to get approval from prime brokers so they could short the stocks. They needed credibility and it is the prime brokers job not only to access the stock to lend to the shorters but to do due diligence on the shorters so they will be good for the trade. That in essence is the prime broker business model, for this service they charge a lot.
The custodian also gets a fee for lending the stock. One day I got stuck into the custodian because really it is the LO managers own stock being sold back at them through the shorters. Like a zombie coming back to life and attacking you—that’s how it felt anyway. Lol. The custodian told me, ok fine, you make good the fee we forego by not doing it then or we will charge your client more! The LO managers have no control, over this process.
What I am not sure of is the reporting and ownership definitions. We see the prime brokers putting in substantial shareholder notices as they gather stock to pass on to their short clients. HF look as if they dont need to put in notices since they are short not long. I presume the PB keep legal ownership through the process but not sure.
The cost of carry is quite high and depends on the availability and demand for certain stocks. Therefore there is some pressure to cover your short as the longer you maintain the position the more it costs you. Timing is of the essence.
One interesting thing is that a LO manager could in theory buy the same stock he owns several times over!
Wherever there is a profit to be made the financial industry can be highly inventive. I am not making any comment on any market efficiency or social good from this whole process!
Hope this makes it a bit clearer