Securities finance is an integral aspect of an investment portfolio and consists of portfolio margin or leverage and stock borrow\loan (settle shorts and lend longs). Financing costs can make a significant impact to a portfolio’s returns adding 50 to 200 bps of expense, and sometimes more, to the bottom line depending on the securities traded. While margin and leverage costs are usually standardized within a prime brokerage or brokerage agreement, stock borrow\loan costs and revenues will vary daily depending on the underlying securities in a portfolio.

Stock borrow sometimes is an ignored aspect to the profitability of a trade because the financing expense effect is usually assumed to be minimal, but not every trade has the 30bps cost of a general collateral borrow and has the capability to take a big bite out of expected Alpha. Total 2022 and 2023 equity stock borrow financing costs for U.S. shorted stocks came in at $6.9 billion per year, which was a significant offset to Alpha generation.

We can do an analysis of short selling and the stock borrow market over the last two years, 2022 which was a down year for the U.S. markets and generally profitable for shorts and 2023 which was an up year for U.S. markets and generally unprofitable for short sellers. While the profit and loss aspect to short selling varied dramatically between the two years, the stock borrow aspect was consistent.

Total average short interest in 2022 and 2023 was $935 billion and $921 billion, respectively. 83% to 84% of short interest was in General Collateral stocks (G.C. or the easiest to borrow stocks at the cheapest stock borrow fees) and only 4.6% to 5.5% of short interest was in stocks with greater than 1.00% stock borrow fee. Most short selling, as expected, was centered around the larger cap and more widely traded and held securities with the largest and cheapest pool of stock loan availability.

The most expensive stock borrow fees in the U.S. are:

While the notional amount of short interest was skewed to G.C. and easier to borrow stocks, stock borrow costs were bar belled between the easiest to borrow stocks and hardest to borrow stocks. A third of stock borrow financing costs were incurred by shorting G.C. stocks even though these trades made up over four\fifths of total dollars shorted while over two\fifths of stock borrow financing costs were incurred by shorting stocks with over 10% stock borrow fee while making up less than two percent of dollars shorted. Short sellers had significantly less dollar exposure in the harder to borrow\more expensive stocks but over two\fifths of their stock borrow expense was generated in those stocks.

The distribution of stock borrow revenues is the reason long lenders and brokers vie for client non-G.C. activity which generate higher spread returns and less balance sheet usage. While the total amount of stock loan revenues for G.C. shorts is large, the spreads are small on an exceptionally large notional amount and service\maintenance to support that portion of an investor’s portfolio is high. It is much more efficient, on a manpower and balance sheet usage basis, to have clients with larger non-G.C. short books.

But, from a short seller’s perspective non-G.C. short trades are also more attractive as they usually use the same amount of a portfolio’s margin capital (although there may be some illiquid or volatile stocks that may require more margin) to generate larger returns. Both in 2022 and 2023 returns on short positions with over 10% stock borrow fees outperformed G.C. shorts by a large margin.

Short trades with high potential and actual returns become crowded as short sellers look for diamonds in the rough and increasingly short sellers build positions in these securities. If they occur in smaller market cap names with smaller stock borrow pools, they can become expensive to borrow very quickly.

With a limited amount of “home run” short trades in the market, short sellers are willing to pay higher stock borrow financing costs in exchange for greater mark-to-market returns on their trades, but the risk is that these securities can become short squeeze traps very quickly. Crowded shorts with rising stock prices and active short covering can produce an avalanche of buying pressure which can move stock prices up quickly and create exit risk in bid-offer imbalances.

Four out of five dollars shorted are in G.C. stocks but only one out of five stocks are G.C., there is a concentration of short side exposure in larger cap, easier to borrow stocks but there are a larger number of stocks in the more lightly shorted harder to borrow stocks. Therefore, there are more stocks that need more careful oversight to manage risk and expenses, but these stocks also have, on average, greater returns.

The risk of short squeezes or high financing costs offsetting more generated Alpha than expected are always a risk in shorting stocks but more so when stocks are hard to borrow and have large financing fees. In addition to normal portfolio management, short sellers must also be aware of daily fluctuations in stock borrow fees and margin requirements which may negatively affect portfolio performance. Financing OMS platforms allow investors to manage and optimize their portfolios on a ticker-by-ticker basis, maximizing net-of-financing returns and minimizing operational, trading and portfolio risk.

Our Blacklight SaaS platform and Black App provides an up-to-date view of short selling and short covering on an equity, sector, index, or country-wide basis allowing investors\traders to better manage their existing long and short positions. The Black MaP and Black App products provide a total view of long and short positioning in the market with a breakdown between Active\Passive long investors, 24 Fund type entities, over 50k securities globally across 108 countries and data from 58 regulatory exchanges.