Monday, July 17, 2006

Short Stocks and Cost of Liquidity

How stock shorting actually works? Is shorting just catering to bearish investors/speculators? What’s the role shorts play in a stock market? This article takes a look at the process and economy behind the stock shorting. We will look at the Risk-Based Profit/Loss and Risk-Free profits in stock trading world. The article is not intended to encourage or discourage you to short stocks.

Shorts, Where Do You Come From?

Let’s start from the very beginning where shares of stock are originated. Consider a simplistic situation: Company XYZ goes IPO and sells 1000 shares of stock at $10. The underwriter, let’s call it Dealer A, is designated to sell the shares to public for XYZ, which actually means Dealer A buys all the shares from XYZ at a lower price (say, $8) of the target IPO price $10 (you can look at this from another angle: Dealer A is making a market for XYZ at the IPO with $8 bid, $10 ask). Supposed an investor A buys all the $1000 shares. Here is a list of all the parties involved and what they have:

Company XYZ: No shares, cash $8000 raised from IPO;

Dealer A: No shares, cash $2000 (profits from underwriting);

Investor A: 1000 shares of XYZ; cash: borrow $10,000 from Bank A. Deposit $2500 for margin requirement, net cash -$7500.

Bank A (for simplicity, assume both dealers and investors use the same bank): Net Deposit $4500 ($2000 from Dealer A, $2500 from Investor A); Net lending: lends Investor A $10,000, net cash position = -$5500. That’s the actual investment from bank to finance the two parties

Act II

Supposed there is a bullish Investor B wants to buy 500 shares of XYZ. Dealer A now has no inventory. So he borrows from the Investor A’s broker 500 shares of Investor A’s shares (when Investor A signs up an account with his broker, he has consented to allow the shares he holds to be borrowed when needed without his knowledge). Now look at the position of each party after the second transaction:

Dealer A: Short 500 shares. Cash: $7000 = $2000 (from IPO) + $5000 (from short sell);

Investor A: 1000 shares of XYZ; cash: -$7500 (unchanged).

Investor B: 500 shares of XYZ; cash: borrow $5,000 from Bank A. Deposit $2000 for margin requirement, net cash -$3000.

Bank A: Net Deposit $11500 (with $5000 from Dealer A, $2000 from Investor B); Net lending $15000 (with lending to Investor B $5,000). Net cash position = -$3500.

Shorts naturally arrive on the dealer side with bullish investors. Where is typical short seller who is bearish and would borrow the shares to sell short hoping to profit from the decline of stock price?

Act III

Investor C is bearish and wants to short 500 shares, if the dealer is Dealer B, that would be perfect, Dealer B closes out his short positions, while the short position is transferred Investor C. Let’s make it a bit more complicate (and realistic): Investor B trades it with another Dealer B. Dealer B will end up long stock after Investor sell the stock short to him. So who is responsible for the borrowing procedure for Investor C? It is the job of his broker (to borrow the shares from Investor A or Investor B), while the counterparty (Dealer B) has no idea whether the shares he buys come from a short trade or from a sale of stock. Now the positions of each party are:

Dealer A: Short 500 shares. Cash: $7000 (no change);

Dealer B: Long 500 shares. Cash: -$5000 (borrow from bank) + $1000 deposit for margin (called haircut in the professional world);

Investor A: 1000 shares of XYZ; cash: -$7500 (no change).

Investor B: 500 shares of XYZ; cash -$3000 (no change).

Investor C: Short 500 shares of XYZ; cash: $7000 ($5000 from short sale, deposit $2000 to bank for margin).

Bank A: Net Deposit $19500 (with $1000 deposit from Dealer B, $7000 from Investor C); Net lending $20000 (with lending to Dealer B $5,000). Net cash position = -$500.

The net asset value of the entire market is unchanged. Only liquidity is changed. The entire world has still only $1000 shares of XYZ. The net cash in the world never changes in trading. Even when the stock price of XYZ changes in any way, cash simply goes from one party’s hand to another, while the equity value (equal to shares outstanding — 1000 shares — times its market price — which changes from minute to minute) is certainly changing constantly.

Risk Based Profit/Loss

In the above example, I assume all transactions priced at $10 between investors and dealers. In reality, obviously that won’t be the case, but that’s not the point of this article. The profits from buy low/sell high or loss from buy high/sell low is universal no matter whether you are long or short. The profit/loss of any party (investors or dealers) due to equity price change is risk based. You have to take risk (hold positions, either long or short) to gain profits (or suffer losses). The risk based profits/losses work in the same way for investors or dealers, as long as they hold positions. In the above example, investor A, B and Dealer B would gain profit if stock rises (they all have long stock positions), while Dealer A and Dealer C would loss (both have short stock positions). The situation is reversed if stock declines.

Risk based Profit/loss is speculative and easy to understand. It is symmetry to long or short, applies equally to investors or dealers, as long as stock moves up or down.

What’s more interesting to understanding is the risk-free profits.

Risk-free Profits

Risk-free profits are earnings that does not come from the stock up and down movements (risks). In a big picture, risk-free profits all goes to the service providers — the brokers, dealers and banks — while all these are cost to investors. These service providers provide liquidity and capitals for the investing public, thus they receive such profits which are not based on the directional risk of stocks (thus the name risk-free). It is important for investors to understand how it works (and how all other parties you deal with in stock trading make they money) and what is the cost for investors to use the liquidity in the stock market.

Brokerage is the commissions earned by the brokers for executing trades. Both parties (investors and dealers) have to pay brokerage, even though dealers typically pay at a more favorable rate than investors due to they large volume. The average rate is about a few pennies per shares (for both parties together), thus for typical NYSE daily volume of 2 billion shares traded, or about 10 billion shares for the entire US stock market, that means each day there is about a few $100 millions risk-free cash go into brokers’ bank account. This is first part of the cost for liquidity in the market place: if there are no brokers, buyers have hard time finding sellers, so it won’t be easy to trade.

2. Bid/Ask Spreads .

Unlike brokers, dealers take risks like investors (holding long or short stock positions). But unlike investors who initiate positions to take risks for speculations, dealers bear risks just to provide liquidity. The reward for bearing risks is the risk-free bid/ask spreads (while that is the cost for investors because they initiate the risk). Dealers always get to buy on bid (lower price) and sell on ask (higher price). The typical spread these days in stock market is quite small, 1c or a few pennies, similar to brokerage rate. Thus each trading day in the stock market, there are a few $100 millions go into the dealer’s profits. However, unlike brokers, who would receive the brokerage in cash, the dealers’ bid/ask spread profits mingle with the risk-based profit/loss for dealers, which typically would overwhelm the spreads (typical stock intraday movements are much larger than 1 penny), thus there is really no such direct cashflow for the bid/ask spreads as risk-free profits for dealers. Nevertheless, statistically speaking, if the stock market is truly random, the risk-based position profit/loss would even out and the risk-free profits from spreads should show as consistent risk-free income stream for dealers.

The Banks (which may actually be the same company as the brokers) provide capitals for both the investors and dealers to make the liquidity possible. So let’s look at what bank would gain from all these transactions.

Banks are market makers of cash, which means they pay the depositors a lower rate (say, 4%) — or buy cash at bid price — and charge loan at a higher rate (say, 6%) — or sell cash at ask price. The loan in the margin account (either investors or dealers) are charged at 6%, while the deposit — if net cash positive — is paid at 4%. Furthermore, the cash from shorting stock may get even a lower rate than deposit, say 3% for investors, or 4% for dealers. Some highly shorted stocks may have a negative interest rate, which means not only the cash from short stock will not earn interests at all, but actually get charged for interests. Let’s use these numbers as example and look at the above transaction example.

For the bank, the transactions look like the following:

Sell $7500 @ 6% (lend $10000 investor A for stock purchase of 1000 shares, deduct $2500 of his deposit).

Buy $2000 @ 4% (Dealer A’s profit from underwriting IPO)

Sell $3000 @ 6% (lend $5000 investor B for stock purchase of 500 shares, deduct $2000 of his deposit).

Buy $5000 @ 4% (Dealer A’s proceeds from shorting 500 shares);

Buy $5000 @ 3% (Investor C’s proceeds from shorting 500 shares);

Buy $2000 @ 4% (Investor C’s margin deposit of $2000);

Sell $4000 @ 6% (lend Dealer B $5000 for stock purchase, deduct $1000 of his deposit for haircut).

The bank has net cash position of -$500, which can be borrowed at the interbank rate (the mid-point benchmark interest rate and have tight bid/ask spread). For simplicity let’s assume this mid-point rate is 5%. For the last transaction for the banks is

Buy $500 @ 5% for net cash.

The total net buying/net sell of cash is $14500, but that is not the investment of the bank. In theory, the bank only needs to borrow $500 and all others are transacting other people’s money. Nevertheless, the regulators require the bank to backup the transaction amount to a certain percentage. Assuming the requirement is 10%, that means the bank has to put up $14500 x 10% = $1450 in capital to backup the above buying/selling of cash. With this capital, the annual rate of returns in the above 3 transactions is 23%!

Obviously the actual gross annual rate of returns for the banks transaction depends on 1) the number of transactions, or how many times $1 cash is allowed to be bought or sold; 2) Spread of borrowing/deposits/short stock rates. In any cases, now we can understand why in the world interest rate of a few percentage, how can a saving/lending bank manages to have a margin of nearly 20 to 50%. For example, Wachovia Corp (WB) has a profit margin of 26%, operating margin 48%, return on equity 14%, all in the time period when the Fed Fund rate is about 4 — 4.5%.

Short Stock and Liquidity Cost

What can we learn from the example and analysis?

1. It is more than likely the dealers is going to be short rather than speculators/investors on the street. When investors buy shares, dealers can step up to compete for the trade to sell to investors. When shorting stock is allowed, not just the dealers with shares in their inventory can come up to take the trade, but any dealers who are willing to use their capital to back up their positions can take part in the competition. After investors buy shares, the results can be 1) Some dealers or some shareholders have lower inventory; 2) Some dealers have short stock positions. This situation is exactly identical to the situation when the investors want to sell shares.

In another word, shorts are the source of liquidity in the market, rather than just catering to the bearish investors. The common label for short sellers as speculators who believe the price of the stock will fall so they can buy the shares back at a lower price is only applicable for part, probably a small part, of short sellers.

In electronic world, the term dealer is becoming blur (in old days, only the well-suited men walking on the NYSE floor can be the dealers). There are many investors trading on electronic markets just to provide liquidity — people willing to commit capitals to take the other side of a trade. In this world, it is even less likely shorts indicate bearish. In all fairness, shorts, just as longs, means liquidity.

If you read the SEC FAQ article about short sells ([1] in references), you can feel the harsh tone again short sellers, while a very conciliating tone for dealers (ironically, the opening statement for SEC is supposedly helping investors). It almost seems like everyone in the professional investment world know shorts are key to the market, but while they talk to the less sophisticate investing public, they want to put a ugly scary face on shorts to deter the investors.

Besides the stock dealers who would handily use shorts for liquidity, there is another important source for short sales: the derivative market makers. Again these short sellers have nothing to do with bearish view when they use shorts to hedge to provide liquidity in the derivative market. I will discuss this aspect in detail in another article.

2. Statistically speaking, if the investors are extremely bullish and keep buying stocks, it is likely the dealers will have more short positions; Conversely, if the investors are bearish and there are a lot of sales or shorts from investors, the dealers are more likely to hold long positions.

Can Disallowing Shorts Distort the Market?

Since liquidity in stock market depends partly on short stocks, in a market that does not allow shorting stocks (such as Chinese or Korean stock markets), liquidity may be artificially depressed. Let’s look at what happens if an investor wants to buy stocks in these markets. The broker has to locate a dealer who actually has shares to sell to complete the transaction. Such restriction has several implications:

1) It nurtures a special class of people as dealers (who have inventory) and draw a clear line between dealers and investors. In a market that allows shorting, anyone can become a dealers, as long as he commits capitals to holding positions, thus the line between investors and dealers becomes blur (especially in the electronic markets).

Such special class of dealers due to lack of shorting can increase public suspicion of dealers. Whether it is justifiable or not, generally Chinese investors are highly suspicious of dealers, afraid of their price manipulation. Allowing short stocks can dismantle such special dealer class. More dealers, with or without inventory, can participate in the competition to sell to investors when investors want to buy shares. In general, active competition from diverse parties can reduce the chance of manipulation by a few major players, and increase pricing fairness.

2) If buying shares by investors are less liquid due to lack of short selling, while selling shares from investors are as unrestricted as in the shortable market (such as US market), such lack of parity in buying and selling actually can cause some anti-intuitive result: in both non-shortable and shortable markets, when investors want to sell shares, there is no special restriction on the dealer side — as long as there is dealer to buy shares, the trade can be done; but when investors want to buy shares, there is restriction on the dealer side — only the ones with inventory can trade. Thus statistically speaking, it is easier for investors to sell shares than buying shares, or easier to hit the bids than lift the asks (investors are always the side who initiate risks and buy on ask, sell on bid). You can imagine what is more likely to happen if it is easier to hit bids than lifting asks: the market is more likely to go down in general than going up, if not all other conditions are the same.

From this angle, Chinese stock market may benefit in both liquidity and health growth if shorting is allowed just like in the US market, rather than as the public belief that shorts can cause market crashes or squeeze liquidity.

Know Your Cost of Liquidity

The cost of liquidity comes from 3 parts (all become risk-free profits for the parties that provides or service liquidity): 1) Brokerage for brokers; 2) Bid/Ask spreads for dealers; 3) Interest rate spreads for banks. Obviously competitions can reduce these costs while increase liquidity. For example, brokerage for stock investors have drop tremendously in past decades; stock market bid/ask spreads have shrink continuous over the years and now become typically 1 penny. But there is still one area that investors really have little control: the interest rate spreads.

The above mental exercise example explaining the economy of each party in stock transaction may surprise you, especially the part about the risk-free return of banks in these transactions — how can they get 23% annual return simply by providing banking service to these few transactions? (A stock investor may be as happy as a clam if he can earn 15% return by taking risk in buying stocks.) You might think I put in some fictitious unrealistic interest rate numbers in the example that boost the net bank income to an unrealistically high level. Well, how about this: go ahead and check with your broker, and find out what interest rate they charge you if you borrow from them (is it higher than 6% as of August 2006?); what rate you get paid for your cash deposit (4%?); what rate you get paid for your short stock cash (do they really pay you more than 3%?) The absolute values are not important, what matter is the spread. Your finding may surprise you.

(The author can be contacted at huangxinw@gmail.com .)