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HBOS nosedive due to stock borrowing?

The recent stories about HBOS share price manipulation stated that stock borrowing and lending was misused to assist in the lowering of the share price. Rumors were created and circulated around the market about HBOS, which created an artificial situation where traders took large short positions hoping to buy back as the share priced dropped making a huge profit. There have been a number of articles written about the damaging impact of stock borrowing and lending, which helps the trader to satisfy their short selling settlement commitment to the buyer. However, in my opinion, mostly, those articles have misrepresented the value of stock borrowing to the liquidity of the market and it's time to put the record straight!    

Stock borrowing/lending against a short sale or bear position has been a major City business for decades and has been fundamental to the liquidity of the London Market and the efficiency of settlement. Without this important facility the London Stock Market would have suffered against all other securities markets and would not hold the power it has today. In fact when I was managing a small Stock Jobbing firm in the seventies and eighties it was an important way of reducing book costs and bringing added revenue. There was often a view by accountants that stock borrowing was a cost, but this was always proved false and personally I proved this with over £1m of added revenue to Hoare Govett Market Making in the year 1984 to 1985.

Without stock borrowing, bear transactions would not settle on settlement day, creating a large market fail position with all the financial problems that would entail for investors on the end of a bear trail. Imagine the problem of a failed settlement if either the purchase was needed to collateralize another position in the market causing it to fail, or if the transaction formed part of an industry chain where a string of transactions was tied to the initial settlement. A bit like buying and selling a house, when a failure at the top of the chain brings all other transactions to a halt, so market settlement liquidity was and still is a major factor in the efficiency of the securities market.

The borrowing of stock used to be highly regulated by the Bank of England (B of E) with only approved money brokers (by the B of E) allowed to act as an agent for their institutional lenders. The institutional lenders were also regulated by a contract with the money broker. In those days the B of E had the full picture of how much was being borrowed and lent and by who and if necessary to ask in what circumstances. In my view the system became open to potential abuse when the Money Brokers were disbanded as being a cartel and the B of E was taken out as the central regulator.

There was a contract between the Lender (Money Broker) and Market Maker ensured that the lending institution could call back their stock at any time. This meant that there was a regulatory process for the protection of the lender, which ensured the borrower did not over commit in borrowing a stock that would prove expensive to buy back. This created a natural dealing valve to limit the risk of taking too high a bear position, or borrowing an illiquid stock. So Market Makers were very careful in what they borrowed as they were contracted to return the borrowed stock, if called back by the money broker on behalf of their institutional client. This is not the case today where there is less regulatory control and with the B of E no longer fulfilling this role and is a contributory factor to the current free for all, thus the risk of borrowing has increased immensely.

Borrowed positions were always marked to market, every day and that meant the position was always measured and within market risk of the borrower and protected the lender. Collateral deposited against the loans was also marked to market and the LSE was instrumental in maintaining that no potential calamity would take place if there was a major price correction in the market. They were forewarned and able to assist the Market Maker or Broker to manage any potentially dangerous position. This was a very effective and important proactive way of the regulator and the LSE working with the Market Maker to protect the lender but more importantly the market. This does not happen as efficiently today as there is no central regulatory force proactively managing the risks of the Market Maker. It's mainly performed after the fact and once the course has been set.

The lending institution was always protected by a legally binding contract and because the Market Makers desperately needed the stock to be lent or it would limit their ability to take short positions. Settling short positions but also taking the interest paid by the money broker was very beneficial to them. The lending institution was also protected in the case of any Corporate Action or in the case of a dividend or any other capital change in the shares of the company lent. So a dividend was always protected and charged against the Market Maker. This caused a manufactured dividend situation that was monitored by the Inland Revenue.

Traders today have many different types of financial product to create a short position. In fact it's more likely that traders will short for a strategy rather than take a naked short position. Investment banks monitor short positions and especially naked shorts. Remember the sky is the limit in potential loss if you hold a naked short and the price climbs to the stratosphere! If a naked short is created the bank will insist that some Option is created to limit the down side. It's why derivatives are a vital part of all trading environments. 

But although there are many different ways for Traders to cover a short position, stock lending and borrowing is vitally important to creating a liquid market. The problem is it's not regulated closely enough. The Bank of England was in the best position but the FSA are not, even if they fully understood the business!


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