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From: Chapman Spira and Carson
Time: 5:24:54 PM
A truly simple concept to understand, but terribly complex when the nuances are examined. The device of loaning stock was created because without it the stock markets in this country literally could not function. Investors do not always deliver sold securities on a timely basis; however, regulations require that settlements occur within the timeframe set by the securities and exchange commission, currently "t +3".
Thus, if the financial instruments that were sold were not delivered, the brokerage firm that was obligated to make delivery would have a "fail" on their books and the "opposing" party might have to "buy the securities in" potentially creating a substantial loss on the seller's books. Naturally the seller would pass on the loss to the tardy customer. In the end that may not help.
So, when a customer determines that he is going to purchase his stocks at the broker "on margin" he is obligated to sign a "hypothecation agreement". This agreement allows the brokerage firm to use the securities of all of their customers who are "on margin" in making delivery to correct their fail. The economics of this transaction are interesting. The broker takes the certificate belonging to one of his customers and gives it to the buying broker, in turn the buying broker gives the selling broker the proceeds of the sale. The selling broker pockets the money until the client makes delivery of the tardy shares. When the shares are physically delivered, all the transactions are reversed. The physical credit is returned to the selling investor and the securities are returned to the "box" or the investor from whom they were borrowed.
What has occurred is a timely settlement of a transaction and a substantial profit for the brokerage firm where the fail occurred. A very profitable deal for the broker, at no cost to the customer, and so seamless that no one on the outside even knew that it occurred. Although the failure to deliver securities is not the biggest use of stock loan, we used it as an example. Now that we have electronic securities, customer insurance (SIPC and additional coverage), people tend to treat the brokerage firm as a depository and thus the number of fails has decreased substantially.
But what has increased is the number of "open short sales" in existence. As volume increases, short sales increase with it. Short sales have historically had a much greater longevity than pure fails, and thus are substantially more profitable than "regular way" transactions. Because of this profit potential every one has attempted to get into the act by acting as a "standby" lender of securities if the broker can't find enough in the "box". Universities like Harvard and Yale were among the first to actively circularize "the street" in effort to loan their fully-paid- for securities because they rightly felt that the loans would generate a substantial profit at only a slight risk. The maker or the brokerage firm always guaranteed these transactions whose client was the seller.
Not only was the "box" of institutions solicited for lendable securities but so were the people that made the short sales. When everyone figured out what was going on, they became king for a day. Brokers began offering them a piece of the action to get the stock loan business. "Rebates" or a percentage of the net stock loan profits were offered big players and it became common practice to give back 85% of the take. Thus, major short sellers soon gravitated to the brokers that would give them the largest rebates. Interestingly enough, those people who don't make timely delivery tend to make enormous profits in areas never thought of before. In these days of low interest rates, total return has not suffered as much as would have been expected.
Stock loan departments, formerly thought of as a place for criminals and bullies have become the toast of Wall Street and now that profits are broken out divisionally, firms for the first time are beginning to see what they have been missing over the years by not taking a greater interest in the area. When we say thieves and bullies, we mean that because the firms did not understand what enormous profits were being generated in this area, they did not police it. Thus, this portion of the securities industry became the hunting ground for those that dealt in cash and met in dark corners. The light has only begun to shine in this arena recently, but the money that has already flown the coop must be considered irrecoverable.
Early strategists that understood the makeup of stock loan and its ability to add to the bottom line made fortunes. Investors like Carl Icahn, who also owned a small brokerage firm and had a head for numbers, soon figured out that by factoring stock loan profit into his transactions he could profitably make trades where others who either did not know about the system or where the divisions of the brokerage firms kept profits earned in a particular division, within the division without giving thought to the broader implications.
Even a greater use of stock loan is in something intriguingly called "bond loan"; same deal but in this case we are dealing with fixed income instruments. With the growth of repo's and reverse repo's this has become a much bigger business than stock loan itself but this is another story for another day.