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The market for borrowing stockIntroductionThe U.S. equity lending market: institutional detailsThe transactionA posts collateral with BA pays B a feeA pays b any dividends/distributions made to owners of KKD during the loanB has the right to recall the share from A at any timeThe lender, B, is no longer the shareholder of record and thus has no voting rightsThe playersEquilibrium, specials and recall riskSustainable specialsThe nature of recall risk and squeezesImplicationsEmpirical facts about the loan marketThe sample and the ability to shortSpecialsRecallsConclusionDefinition of stock characteristic variablesReferencesJournal of Financial Economics 66 (2002) 271–306The market for borrowing stock$Gene D’AvolionGraduate School of Business Administration, Harvard University, Morgan 480, Soldiers Field Boston,MA 02163, USAReceived 12 June 2001; accepted 21 March 2002AbstractTo short a stock, an arbitrageur must first borrow it. This paper describes the market forborrowing and lending U.S. equities, emphasizing the conditions generating and sustainingshort-sale constraints. A large institutional lending intermediary provided eighteen months (4/2000–9/2001) of data on loan supply (‘‘shortability’’), loan fees (‘‘specialness’’), and loanrecalls. The data suggest that while loan market specials and recalls are rare on average, theincidence of these short-sale constraints is increasing in the divergence of opinion amonginvestors. Beyond some threshold, investor optimism itself can limit arbitrage via the loanmarket mechanism.r 2002 Elsevier Science B.V. All rights reserved.JEL classification: G12; G14Keywords: Short-sale constraints; Securities lending; Limits to arbitrage; Divergence of opinion1. IntroductionThe SEC defines a short sale as ‘‘the sale of a security that the seller does not ownor that the seller owns but does not deliver. In order to deliver the security to thepurchaser, the short seller will borrow the security, typically from a broker-dealer or$I am grateful to Malcolm Baker, Raphael La Porta, Andr!e Perold, Andrei Shleifer, Jeremy Stein, ananonymous referee, and seminar participants at Harvard University for helpful comments. I also thankBracebridge Capital, Citadel Investment Group, the Risk Management Association, State Street Bank,and UBS Warburg for their cooperation in this research effort.nCorresponding author.E-mail address: [email protected] (G. D’Avolio).0304-405X/02/$ - see front matter r 2002 Elsevier Science B.V. All rights reserved.PII: S 0 3 0 4 - 405X(02)00206-4an institutional investor.’’1The ease of selling a stock short is crucial for effectivearbitrage. Finance theory often makes strong assumptions about the ability ofrational arbitrageurs to costlessly borrow and short arbitrarily large amounts of stock.In essence, this short selling represents the creation of new supply that arbitrageurscan bring to bear on exuberant but downward-sloping demand. Friedman (1953),Fama (1965, 1970), and Ross (1976) are classic examples of a literature that relies onunfettered arbitrage. In contrast, Diamond and Verrecchia (1987), De Long et al.(1990), Shleifer and Vishny (1997), Hong and Stein (1999) and Chen et al. (2002) focuson implications of constrained short selling or, more generally, the limits of arbitrage.Miller (1977) shows that when short selling is constrained, the marginal investor willbe an optimist when a divergence of opinion exists.The goal of this paper is to describe the market for borrowing and lending stock —the very mechanism of short selling. After detailing its institutional and regulatoryaspects, I present an informal explanation of how the securities loan market reachesequilibrium along with the spot and derivative markets. This approach places short-sale constraints, typically treated simply as ‘‘transactions costs,’’ into a supply anddemand framework where economic intuition can be mobilized. The short seller’scost (lender’s income) is recognized as a market-clearing loan fee and short interestas a market-clearing loan balance.The brief description of equilibrium is useful for isolating the conditions requiredto sustain high loan fees (i.e., ‘‘specialness’’). For the market to clear, theoutstanding securities must come to rest with non-lending investors willing to holdthese securities despite forgoing the loan fees capitalized into the equilibrium price.This implies that non-lending investors in special (high lending fee) securities, for anynumber of reasons, place a relatively higher value on the securities and have limitedaccess to ‘‘cheaper’’ substitutes such as forwards or options. It also suggests that thecost of borrowing stock is increasing in the dispersion of investor valuations. Whileshort sales constraints might be small on average, they are systematically high whendifferences of opinion are high — a dynamic that broadens the applicability ofMiller’s (1977) model of optimistic prices.The paper also describes how a stock lender’s option to cancel the loan (‘‘recall’’the shares) at any time imposes risk on the short seller. Without a guaranteed termloan, the short seller is exposed to changes in the relative valuations of the marginalinvestor and the marginal lender. When the correlation between these changes ishigh, the expected costs of covering or replacing a recalled loan are minor. When thiscorrelation is low or negative, the recalled short seller might need to cover the shortposition in a rising market — thus being stripped of expected profits and potentially‘‘squeezed’’ for additional losses. We also see that differences of opinion, byincreasing the turnover that dislocates loans, make recall more likely. Theory thussuggests that short sellers might prefer certain lenders (passive indexers) to others.Duffie et al. (2002) provide related work with a multiperiod model of the equityloan market that emphasizes the search process faced by borrowers and lenders. Inaddition, Duffie (1996) and Krishnamurthy (2002) derive equilibrium models of the1This definition can be found on the SEC website, http://www.sec.gov/rules/concept/34-42037.htm.G. D’Avolio / Journal of Financial Economics 66 (2002) 271–306272market for borrowing US Treasury bonds (the ‘‘repo’’ market). A common elementin these models is investor heterogeneity, which generates borrowing (short selling)demand and explains why non-lenders hold securities despite


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