If you ever wondered precisely what has to happen when shares are sold short, this lesson describes it perfectly. The mechanics behind short sale transactions are detailed one step at a time to help viewers understand what the investor must do, and more importantly, what his broker must do to prevent the trade from failing.
A Trader decides to sell a stock short in the hopes of being able to repurchase it at some later point in
time at a lower price.
In order to make delivery of the stock, Trader A will need to actually have shares for delivery, so their
broker will need to borrow stock from internal inventory or another broker. Brokers keep a list of
available inventory on what is called a Box List. Brokers populate the Availability List through their own
available customer, shares from other brokers, and from large institutions. Internal broker availability is
derived from customers that purchase stock on margin and fully paid shares made available via the
Stock Yield Enhancement Program.
Trader A, having found a source to borrow the shares (2), executes a short sale transaction on trade
date, or “T” (3). Most major equity markets have a 2-day settlement period, i.e. the actual exchange of
shares versus cash occurs on T+2, 2 business days after trade date. Settlement date is sometimes also
referred to simply as “S”.
On the morning of Settlement Date or T+2, Trader A’s brokers Securities Lending Department
determines its actual delivery obligations for that day. They consult their own Availability List and if
inventory is not available for internal borrowing, they consult the Availability Lists of other brokers.
Borrow transactions are arranged and the delivery of the shares from the lending broker to the
borrowing broker is effected if needed. These borrowed shares (4) provide Trader A’s broker with the
necessary inventory to deliver onward to settle the short sales (5).
It is important to understand that there will be situations where a given stock appears to be borrowable
on T, but in the intervening 2 days, the availability changes such that on T+2, it is no longer borrowable.
This creates a situation in which the short sale trades will “fail”. In other words, the timely delivery
obligation will not be met by the broker. In this case, a forced repurchase, or “close out” may be issued
by the broker and the resulting trade will be charged to the trader’s account, thereby reducing or
eliminating the short position.
In exchange for Trader A selling the borrowed shares, the cash received from selling the shares is used
as collateral on Trader A’s borrowed shares (6).
Trader A’s Broker invests the cash collateral and uses a portion of the interest to pay administration fees
and stock borrowing fees. Because of steep administration costs, remaining interest is generally only
paid out to large balance short sellers. In certain hard to borrow cases, borrowing fees are so high
(greater than the interest earned) that the short seller needs to pay for the privilege of borrowing
Any dividend earned during the term of the stock borrow will be paid to the borrower (Trader B) who
holds the borrowed shares. The Lender of the Shares (Trader C) will be paid an equivalent cash amount
by the Short Seller (Trader A) in what is called Payment in Lieu of Dividends.
Disclosure: Interactive Brokers
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