What’s a pre-borrow?

By Felix Salmon
June 4, 2009

Alistair Barr reports that the SEC is “cautious about imposing a broad pre-borrow requirement as a way of limiting manipulative short selling because the costs could outweigh the benefits”. This confused me: isn’t naked shorting precisely what happens when you short a stock which you haven’t borrowed? And isn’t it illegal? Why all this fuss about a rule which forces shorters to borrow the stock in question first? If they don’t borrow the stock in advance, aren’t they shorting it nakedly?

Turns out, it’s a bit more complicated than that, thanks to the T+3 settlement system. On the day that you short a stock, you don’t need to borrow it, you just need to locate it. That means looking it up on an “easy to borrow” list, or phoning up a dealer and asking for a locate. Once you’ve got a locate, you can then go ahead and put in your sell order, even if you haven’t actually borrowed the stock. In fact you don’t actually borrow the stock until three days later, when the trade settles.

It’s not easy to work this stuff out, amid all the talk of “interim final temporary rules” and the like. But basically the debate comes down to a simple question: do you borrow before you sell, or do you only borrow when you settle? The SEC doesn’t want to force people to borrow stocks before they sell, because they say, and I believe them, that doing so would increase borrowing costs and hurt liquidity — all in the service of addressing a problem (naked shorting, which results in people not providing the shares at settlement) which is not obviously much of a problem at all.

Still, in some real sense nearly all short sales are naked short sales, in that the person doing the sale doesn’t actually have the stock to sell: they only borrow it three days later, at settlement.


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Moving to T+1 or T+2 is a much better solution than forcing these interim and arbitrary rules. That is a long term solution and will not deter liquidity as much as ad hoc rules may do.

See, there’s another derivative the SEC regulates: the three-day forward contracts that trade on NYSE.

Felix, since you have spent so much time writing about all these short sale issues I would have expected that you at least understood the issues.

The reason for a mandatory pre-borrow is to address the abuses in the stock locate and short process. Hedge funds have found a way to short more than shares available in locate with INTENT on a failure. The pre-borrow addresses this issue. The pre-borrow similarly imposes a fee on those short sellers who want to sell short and cover within the settlement window. Presently day trading short allows you to throttle stocks intra-day without ever taking ownership of what you sell to another. This too has become abused.

As for borrowing costs, that is yet another PR pitch from the short sellers who can’t justify the rhetoric. Short sellers in 2004 claimed that Reg SHO would reduce liquidity in the markets if the SEC imposed these restrictions. It never happened. A pre-Borrow at trade vs. a Borrow at T+3 is negligible in cost and adds protection to the markets. It also reduces those 700 Million shares that rest on the CNS system as failed each day. The fact that the threshold list is smaller is illustrating a change in the style and process used in shorting today. Short sellers must punish stocks more quickly because the time to cover has reduced.

Posted by Dave | Report as abusive

Somebody has to explain to me the difference between a put option and a naked short sale. Reading about Bear Stearns downfall, and the role that put options can play in driving down a stock price, is cause for great concern. If a stock’s price is $50, and somebody buys a 10 day put option with a strike price of $30, he has virtually no risk, because the trade is optional. Some hedge fund manager does a $1 billion dollar put option on those terms, several others jump on the bandwagon, and the value of the stock will almost certainly drop like a rock, regardless of the genuine value of the stock. And, again, if it does not drop, he loses nothing, except for some fees. It makes a great deal of sense to ban short selling, but we need to close this loophole also.

Posted by Randy Miller | Report as abusive

Do you know how the “borrowed shares against short sales are actually settled i.e. since the buyer has only borrowed and not bought these shares, how and when does he submit them through the NSCC CNS cycle and what happens at DTC since the ownership is still with the stock lender?

Posted by Jash | Report as abusive