Borrowed shares

Borrowed shares are a fundamental component of the securities lending market, a critical aspect of modern portfolio management and a subset of financial markets. Specifically, "borrowed shares" refers to shares of stock or other securities that an investor, typically a short seller, obtains from a lender (often a large institutional investor or custodial bank) for a specified period, usually with the intent to sell them immediately. This practice facilitates various trading strategies, most notably short selling, where the borrower aims to profit from a decline in the security's price.

History and Origin

The concept of borrowing shares is intrinsically linked to the history of short selling, a practice that dates back centuries. Early forms of short selling appeared in the Dutch Republic in the early 17th century, notably involving shares of the Dutch East India Company. Isaac Le Maire is often cited as one of the first known short sellers, attempting to profit from a decline in the company's stock by selling shares he did not yet own. Over time, the informal arrangements for borrowing stock evolved into more structured agreements. In the United States, short selling gained prominence, particularly around the 1929 stock market crash, leading to increased scrutiny and the implementation of regulations like the "uptick rule" in 1938 by the U.S. Securities and Exchange Commission (SEC) to manage its impact on market stability. These historical developments underscored the necessity of a formalized process for borrowing shares, as brokers began to facilitate these transactions, often lending shares from their clients' margin accounts.⁶ The need for formal rules around hypothecation (lending) of customer shares also emerged, with some early restrictions imposed by exchanges, such as requiring written authorization from customers before lending their shares.⁵ The Federal Reserve Bank of San Francisco notes that short selling has long been a feature of financial markets, serving various functions despite periods of controversy.⁴

Key Takeaways

Borrowed shares are securities obtained by a borrower from a lender, typically for the purpose of short selling.
The transaction involves an agreement to return the same number of shares at a later date, regardless of price fluctuations.
Borrowers usually pay a fee or interest rate to the lender for the use of the shares and must post collateral.
The availability and cost of borrowed shares can significantly impact the feasibility and expense of short selling.
Securities lending plays a role in market liquidity and price discovery.

Interpreting Borrowed Shares

The number of borrowed shares for a particular security, and the associated borrowing costs (often expressed as a percentage of the share's value), provide insight into market sentiment and the intensity of short selling interest. A high volume of borrowed shares, especially when coupled with increasing borrowing fees, suggests strong bearish sentiment among investors, indicating that many believe the stock's price will fall. Conversely, a low number of borrowed shares or declining fees might indicate less conviction in a price decline or a reduced appetite for shorting. The ease with which shares can be borrowed (i.e., their availability) is a direct measure of supply in the stock loan market. For instance, "hard to borrow" stocks are those for which few shares are available for lending, typically leading to higher borrowing fees. This availability can impact how easily market makers can facilitate certain trades.

Hypothetical Example

Imagine an investor, Sarah, believes that XYZ Corp.'s stock, currently trading at $50 per share, is overvalued and will decline. To act on this belief, Sarah wants to short sell 100 shares. She contacts her broker-dealer, who locates 100 shares of XYZ Corp. available for lending from a large institutional lender.

Borrowing: Sarah borrows the 100 shares. Her broker-dealer facilitates this, typically requiring Sarah to deposit collateral (often 102% of the value of the borrowed shares, or $5,100, in her margin account).
Selling: Sarah immediately sells the 100 borrowed shares in the open market for $50 each, receiving $5,000.
Waiting: Sarah now waits for the stock price to drop. During the time she holds the borrowed shares, she must pay a daily borrowing fee (e.g., an annualized interest rate of 0.5% on the value of the shares) to the lender. If XYZ Corp. pays a dividend during this period, Sarah is also obligated to pay an equivalent amount to the lender, as the lender would have received the dividend if they still held the shares.
Covering: A month later, XYZ Corp.'s stock price falls to $40 per share. Sarah decides to "cover" her short position. She buys 100 shares of XYZ Corp. from the open market for $40 each, costing her $4,000.
Returning: Sarah returns the 100 shares to the original lender.
Profit Calculation: Sarah's gross profit from the trade is $5,000 (initial sale) - $4,000 (buy to cover) = $1,000. From this, she subtracts the borrowing fees and any dividends paid.

Practical Applications

Borrowed shares are central to the functioning of securities lending and facilitate several key activities in financial markets:

Short Selling: This is the most direct application. Investors borrow shares to sell them, anticipating a price drop. This strategy is used for speculation, hedging, and arbitrage.
Market Making: Market makers often borrow shares to ensure continuous two-sided quotes, providing liquidity by facilitating buy and sell orders. They may temporarily go "short" if a sudden influx of buy orders exhausts their inventory, borrowing shares to fulfill demand.
Arbitrage: Borrowed shares enable arbitrage strategies, where traders exploit price discrepancies between different markets or securities by simultaneously buying undervalued assets and selling overvalued, often borrowed, assets.
Failed Trades: In instances where a seller fails to deliver securities on time (a "fail-to-deliver"), a broker-dealer might borrow shares to fulfill the delivery obligation, preventing settlement issues.
Regulatory Compliance: Regulators, such as the SEC, monitor borrowed shares and short selling activity. For example, Regulation SHO imposes requirements for broker-dealers to locate shares before a short sale can be executed.³ The global securities finance market, which includes borrowed shares, continues to generate significant revenues, highlighting its vital role in capital markets.²

Limitations and Criticisms

While integral to market efficiency, the practice of borrowing shares and subsequent short selling faces several limitations and criticisms:

Unlimited Loss Potential: Unlike a long position where losses are capped at the initial investment, short selling carries theoretically unlimited loss potential. If the price of the borrowed shares rises indefinitely, the short seller must eventually buy them back at a higher price to return them to the lender.
Borrowing Costs and Fees: Borrowing shares incurs costs, including an interest rate on the loan and potential payments for dividends or other corporate actions. These costs can erode profits or exacerbate losses.
Recall Risk: The lender of the shares can "recall" them at any time, requiring the borrower to return them. If the borrower cannot find other shares to borrow, they are forced to cover their position, potentially at an unfavorable price.
Market Manipulation Concerns: Critics argue that aggressive short selling can sometimes contribute to downward price spirals or even be used in manipulative schemes, though regulations like Regulation SHO aim to prevent abusive practices.
Impact on Shareholder Rights: When shares are borrowed, the lender typically temporarily forfeits proxy voting rights to the borrower for the duration of the loan. This can affect corporate governance, particularly in situations where voting rights are critical.
Liquidity Strain: In highly volatile or illiquid markets, the sudden demand for covering short positions can create a "short squeeze," where an escalating buying frenzy further drives up prices, making it difficult and expensive to return borrowed shares.
Academic research has explored the effects of stock loans on security prices. Some studies, through experiments, have found that while supply shocks in securities lending can reduce lending fees, they may not necessarily have adverse effects on stock prices.¹ This suggests a complex interplay between the supply of borrowed shares and overall market dynamics.

Borrowed Shares vs. Short Interest

While closely related, "borrowed shares" and "short interest" refer to distinct concepts.

Borrowed Shares: This term specifically denotes the actual number of shares that have been obtained from a lender by a borrower through a securities lending agreement. It represents the supply side of the short selling equation—the shares available and taken for a loan. A high number of borrowed shares for a particular stock means many investors have actively arranged to take possession of those shares, likely with the intention to sell them short.

Short Interest: This metric represents the total number of shares of a security that have been sold short by investors and have not yet been "covered" or bought back. It is a measure of the demand for short positions. Short interest is typically reported periodically (e.g., bi-monthly) and is often expressed as a number of shares or as a percentage of the company's total outstanding shares or float. High short interest indicates significant aggregate bearish sentiment towards a stock.

The distinction lies in their measurement: borrowed shares are about the act of borrowing itself (the supply of loanable stock), whereas short interest is the cumulative open positions resulting from those borrowing and selling activities (the outstanding bearish bets). A stock can have many shares available to be borrowed (high potential borrowed shares) but relatively low actual short interest if investors are not actively shorting it. Conversely, a stock with high short interest necessarily implies that a large number of shares have been borrowed.

FAQs

What is the primary reason investors borrow shares?

The primary reason investors borrow shares is to engage in short selling. They sell the borrowed shares immediately, hoping to buy them back later at a lower price and return them to the lender, profiting from the price difference.

Who typically lends shares in the market?

Shares are primarily lent by large institutional investors such as pension funds, mutual funds, and custodial banks that hold significant portfolios of securities. They do this to earn additional income on their long-term holdings through securities lending fees.

Do borrowed shares affect the stock price?

Borrowed shares, especially when followed by actual short sales, can contribute to downward pressure on a stock's price, as they increase the supply of shares available for sale in the market. However, the overall impact on price is complex and depends on many factors, including market liquidity and the prevailing sentiment.

What are "hard-to-borrow" shares?

"Hard-to-borrow" shares are securities for which there is limited availability for securities lending. This scarcity can result from high short interest, limited institutional holdings, or active efforts by existing shareholders to prevent their shares from being lent out. Borrowing such shares typically incurs higher fees.