Short-selling, the supply side: Are lenders price makers?
| Autor | Casula, Daniel de Sales |
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Introduction
Short selling now comprises a significant volume of shares traded, increasing the importance of the short market. Most researchers in this area focus on the demand side of the market. Studies suggest that lending fees capture private information from short sellers, on the demand side. Meanwhile, stock lending (supply side) is usually considered not to influence lending fees.
Part of this passive behavior of lenders may be explained by the opacity of the market, that is, by the limited information on borrowing demand in a nontransparent OTC market. However, recent modernization of the securities lending market, with timely information and online platforms, has given lenders a better position to proactively price their lendable assets and manage supply (Duong et al., 2017).
Although most previous researchers on short sales argue that high lending fees predict negative returns, since high fees capture negative information held by short sellers, some recent authors (e.g., Duong et al., 2017) argue that high lending fees predict negative returns even after controlling for shorting demand. They suggest that an additional information component must exist on the supply side.
Following such debate, the goals of this paper are twofold. First, we want to verify whether lenders are price makers. More specifically, we want to verify whether lenders modify loan conditions (price and quantity) independently of changes generated by the demand side. Second, we want to see if lenders are informed and if they use public information to change their lending offers.
Using Brazilian data, we confirm that high lending fees predict negative stock returns. We argue that the supply side, where stock lenders provide supply for fees, also warrants attention. We disentangle the shifts in supply and demand using the technique of Malloy et al. (2005). Then we explore the effect of these shifts on future stock returns. Our results indicate that shorting supply has a statistically relevant relationship with future stock returns. More precisely, we find that lenders decrease loan supply when they predict negative future returns. Thus, we conclude that lenders are active; they modify loan fees and quantities after controlling for changes in the demand side.
For our second goal, we start by confirming the importance of new information in the market. We find that relevant announcements have significant impact on securities prices and on investors' decisions to trade. Therefore, it behooves us to relate announcements to the supply curve to help characterize whether and how lenders use new information to modify their lending offers.
Since only relevant information is likely to affect securities prices, we separate different types of announcements into categories, following B3's (1) classification. Many announcements contain irrelevant information, which could lead to an underestimation of announcements' impact on the market. Additionally, some announcements include news that is no surprise to the market--these would mitigate their overall impact on stock returns. Therefore, in our models, we consider only announcements of relevant facts and of economic-financial data.
Moreover, positive and negative announcements tend to affect securities prices differently. An announcement is said to be positive if the difference between the stock return minus the expected stock return on day t is greater than zero; and negative if the difference is less than zero. To include some announcements considered to be neutral, we also run our models with an interval imposed for positive and negative announcements.
By separating different categories and the sign of announcements, we find that lenders do process them when they are released. More specifically, when lenders are informed of positive news, they increase their shorting supply--decrease their restriction of shorting supply. By contrast, negative announcements induce lenders to increase restriction of shorting supply. Our results also indicate that lenders are more responsive to economic-financial data announcements to modify their offers. Despite B3 classification of announcements as relevant facts, some of their information may provide no clear perspective on stock returns. In contrast, information from economic-financial data announcements seems clearer and easier for lenders to understand. Overall, we conclude that lenders do process information when it is released.
Together, our findings indicate that lenders are not simply price takers. They change their lending offers when they predict negative future returns, and they also use new information to modify supply conditions.
Lastly, Brazil's regulatory structure contributes to this research question. In Brazil, all lending deals must be registered in the B3 lending platform. This is unlike most other lending markets. This unusual feature allows for a complete picture of lending activity for the whole market at a daily frequency. In addition, Brazil's market has the same standard empirical facts as the equity lending market documented in the US and Europe (Chague et al., 2019).
The rest of this paper is as follows. Section 2 discusses the literature on short selling activity and its market. Section 3 discusses the Brazilian stock loan market, highlighting its peculiarities, and the data set we use. Section 4 presents the empirical approach and results, and Section 5 concludes.
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Literature review
Short selling is very common in advanced countries, comprising a significant percentage of the volume of shares traded, e.g. 24% on the NYSE and 31% on Nasdaq in 2005 (Diether et al., 2009). The practice is similar in Brazil. In recent years, short selling corresponds to 25% of the volume of shares traded (Chague et al., 2019).
Despite its widespread use, agents have mixed feelings about the implications of short selling. On one hand, some suggest that short selling improves the efficiency of market information (e.g., Saffi and Sigurdsson, 2011; Boehmer and Wu, 2013, among others). Along these lines, several empirical researchers argue that short selling is beneficial to the market. Short sellers convey new negative information. They even perform a governance role by uncovering profit manipulation and discouraging fraudulent activities (Duong et al., 2017). Additionally, Massa et al. (2015) suggest that short selling encourages insiders to release private information, and Deng and Gao (2018) say that short selling plays an important role in monitoring firm insiders.
On the other hand, some consider short selling a dangerous operation, seeing it as an inherently speculative. For instance, in 2011, some European countries banned short selling in an effort to reduce volatility and mitigate a downward spiral in stock prices. However, Alves et al. (2016) find that these bans hampered liquidity. Bid-ask spread increased following the bans' implementation. They find that stocks subject to the bans exhibit a longer delay in assimilating negative common-wide information over the course of the bans, meaning that these regulations have failed to achieve their goals.
Given the importance of the short market, researchers have devoted considerable attention to the practice, mostly focusing on the demand side of it. Lending fees are widely believed to capture information from short sellers. Engelberg et al. (2012) argue that the information advantage of short sellers lies in their ability to process publicly available information. Karpoff and Lou (2010) and Boehmer et al. (2020) find evidence that short sellers actually anticipate earnings surprises, financial misconduct, and analyst downgrades. Chague et al. (2017) argue that well-connected short sellers with low demand costs pay significantly lower lending fees. They show that short sellers, both individuals and institutions, profit from their skills rather than from private information.
Regarding market structure, Kolasinski et al. (2013) argue that research costs in the capital loan market represent significant barriers to short sellers, and that lowering barriers would improve the operation of this market. According to Kolasinski et al. (2013), the stock lending market remains relatively opaque, despite increased accessibility of electronic networks. These authors claim that research costs can be reduced or possibly eliminated by the creation of a central reporting mechanism for sharing prices and loan availability. Accordingly, recent regulatory and market changes give potentially more bargaining power to lenders, placing them in a better position to manage their lending desks (Duong et al., 2017). Lenders have responded eagerly to maximize income from their portfolios (SEC, 2014).
On the supply side of the market, Duong et al. (2017) state that high lending fees predict negative returns even after controlling for shorting demand. They suggesting that an additional information component exists on the supply side. They posit that lenders incorporate not only the past and current shorting demands, but also the expected future demand in their lending fees. Duong et al. (2017) conclude that, along with short sellers, lenders contribute to the price discovery process. However, these authors' proxy for shorting demand (short interest) is controversial--it actually represents the intersection of supply and demand. A low level of short interest may not indicate low shorting demand, since stocks that are impossible to short have an infinite shorting cost, coupled with a zero level of short interest (Malloy et al., 2005).
Several authors construct proxies for shorting supply, shorting demand, equilibrium price (e.g., rebate rate), and equilibrium quantity (e.g., short interest). Asquith et al. (2005) combine both short interest and institutional ownership data to identify stocks with high shorting demand and low shorting supply. Malloy et al. (2005) criticize the use of these proxies and propose a new...
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