Bloomberg
The biggest players in the short selling game are getting a ticket
(Bloomberg) – It’s on the air again, on Reddit, on Congress, on the C-suite: Hedge funds that get rich by selling short are the enemy. The strange thing is that the biggest players in the game are getting a ticket. These would be the asset managers, pension plans and sovereign wealth funds that supply the vast majority of the bonds used to assume pessimistic positions. Without companies like BlackRock Inc. and State Street Corp., the California Public Employees’ Retirement System and the Kuwait Investment Authority playing such an elementary role, investors like Gabe Plotkin, whose Melvin Capital Management has become a piñata for day traders at GameStop Saga Corp., would have no shares to sell short. “Whenever we sell a stock, we find a loan,” Plotkin said on February 18 at the House Financial Services Committee hearing on GameStop’s short-term tightening. There is a lot to choose from. By mid-2020, about $ 24 trillion in shares and bonds were available for this type of loan, with $ 1.2 trillion in shares – equal to one-third of all hedge fund assets – actually borrowed, according to the International Securities Lending Association. It is a situation that superficially defies logic. Given the popular belief that short sellers create unjustified losses in some stocks, why would shareholders want to provide ammunition to attack their investments? The explanation is quite straightforward: by lending bonds for a small fee plus interest, they can generate extra income that increases returns. This is critical in an industry where fund managers are paid to exceed benchmarks and are especially valuable in a low-income world. Compensation is simple: for investors with large and diversified portfolios, a single stock plummeting under the weight of a short sale campaign has little impact in the long run. And in the shortest time, the greater the number of aggregate bets against a stock – the so-called short interest – the higher the rate that a creditor can charge. In the case of GameStop, short interest rates were exceptionally high and the borrowed shares were generating an annual return of 25% to 30%, Ken Griffin testified at the February 18 hearing. Griffin operates a market maker, Citadel Securities, as well as Citadel, one of the largest hedge funds in the world. “Bond lending is a way for long-term holders to generate additional alpha,” said Nancy Allen of DataLend, who compiles data on bond financing. “Originally, it was a way of covering costs, but in the past 10 to 15 years it has become an investment function.” Not everyone is comfortable with the inherent conflict. In December 2019, Japan’s $ 1.6 trillion Government Pension Investment Fund stopped lending its shares in international shares to short sellers, considering the practice inconsistent with its fiduciary responsibilities. At the time, the decision cost GPIF about $ 100 million a year in lost revenue. The US Securities and Exchange Commission has regulated short selling since the 1930s and monitors the market for abuses, such as short selling, which involves taking a short position without sharing loans. Proponents of short selling argue that its use increases liquidity, improves prices and plays a critical role as a bulwark against fraud and exaggeration. Chief executives, whose compensation packages often depend on stock performance, routinely condemn short sellers as vultures. More recently, shorting has been criticized for emotionally charged pranks on Reddit’s WallStreetBets forum. Some speculators raised the prices of GameStop, AMC Entertainment Holdings Inc. and other meme stocks in January to punish the hedge funds that bet against them, and were delighted when the rampant purchase led to blunt losses at Melvin, Maplelane Capital and Citron Research . Many of the key players in the GameStop frenzy testified at the February 18 hearing. Plotkin was asked by committee members about Melvin’s short position. Citadel’s Griffin and others faced broader short selling questions. Even so, no one asked about the offer of borrowed shares and there was no call for witnesses from the securities lending industry. There is a symbiotic relationship between hedge funds and the brokerage units of Wall Street companies, many of them based on securities lending. Major brokers act as intermediaries, providing stocks and bonds to borrowers who wish to short sell them and facilitate negotiations. According to DataLend, securities lending generated $ 2.9 billion in brokerage to brokerage revenue in 2020, almost the same as in 2019. Demand for short positions should already fall, as stock prices have reached historic levels . Now, with the threat of retribution from the Reddit crowd, it may weaken further. Griffin said he “has no doubt” that there will be less short selling as a result of the GameStop squeeze. “I think the whole industry will have to adapt,” said Plotkin at the hearing. “I don’t think investors like me want to be susceptible to this type of dynamic.” This could threaten not only the brokers who trade the stock loans, but also the holders who supply the securities and participate in the revenue. They harvested $ 7.7 billion globally in 2020, down from a record of nearly $ 10 billion in 2018, according to DataLend. Loan rates increased 4.2% on a year-over-year basis in February after the GameStop attack, says DataLend. Although securities lending represented $ 652 million, or just 4%, of BlackRock’s revenue in the fourth quarter of 2020, there is little cost involved and the risks are low because borrowers must provide a security equal to or greater than the loan amount. At both BlackRock and State Street Corp., the second largest custody bank, the value of the bonds borrowed on December 31 jumped at least 20% from the previous year, to $ 352 billion and $ 441 billion, respectively. it has indexes, ”said John Rekenthaler, vice president of research at Morningstar. “You are taking coins from the street, but there are a lot of coins.” Others can also be reached. Just as Robinhood Markets is able to offer zero-commission trades by selling its order flow to Citadel and other market makers, asset managers typically pass on part of their bond lending revenue as a type of discount to the customer. “It is very important to remember that institutional investors get substantial returns from participating in the bond lending market,” said Griffin of Citadel at the GameStop hearing. “This reverts to the benefit of pension plans, ETFs, other pools of institutional loans that participate in the bond lending market.” (Adds data on loan rates after the short interest graph.) For more articles like this, visit bloomberg.comSubscribe now to stay ahead with the most trusted business news source. © 2021 Bloomberg LP