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Trading The Lending Markets

 

For most of us, what goes on in the so called “middle and back office” of a bank or investment operation is a mystery that need not concern us. And rightfully so, buying or selling a financial security such as a stock, bond or commodity and having it appear in our brokerage account is a highly standardised process these days. Most of everything is automated, and the relevant data is exchanged between the many different counterparties very efficiently. Relatively boring, when compared to trying to make money from investing in the assets and having to deal with market risk. But is there more to these operations and have these basic mechanics of the financial services industry now taken on a life of themselves?

 

Consider stock lending. This little-known area of finance certainly offers a fascinating glimpse into the ingenuity of financial engineering. Take a large pension fund or insurance company, who believe in the long-term growth of equities and therefore buy and hold millions of shares of publicly traded companies, often for many years and even decades. Now take professional traders, who tend to buy and sell securities for a matter of days or weeks, and who don’t care about whether things go up or down, they only care if they make money.

 

If the traders think that a particular stock has gone up too far in the last few days, they may want to bet on the price falling. Well, you can’t sell something you don’t have, so you have to borrow from someone else (who might not need it for a while). Think of the car your neighbour has and that sits in the garage for most of the year. If you could agree to take the car for a week at a price and guarantee its safe return, it is the same as borrowing 100,000 shares of Vodafone from a pension manager, and (short) selling them in the market.

 

The pension fund would still have the 100,000 shares on their books (just like the car would still be owned by the neighbour), and we have to pay them any gains (if the stock price went up) as well as any dividends as part of our agreement. The trader also needs to pay a fee for the borrow and is otherwise dependent on Vodafone to go down and buy back the shares, to make any money. Everyone wins, and it is the sheer mechanics of how to account for all of these things efficiently that has enabled a huge market, where trillions of dollars’ worth of stock are lent out for different reasons, time periods and prices all over the world in Nano-seconds.

 

Sometimes, so called “squeezes” on stocks occur, when there is speculation of a take-over and the owners need back that which they have lent, sooner than expected. The short seller is then forced to buy back the stock in the market at any price, which can cause sudden spikes in the value of the shares. It is a mesmerising market, which has driven much of the boom in trading strategies and created an entire industry in the last four decades. Who knew?

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