Duration: 3:51
Level: Advanced

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 their broker must do to prevent the trade from failing.

Study Notes:

An investor 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, Investor 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 inventories on what is called a Box List. Brokers populate the Availability List through their own available clients, shares from other brokers, and from large institutions. Internal broker availability is derived from clients that purchase stock on margin and fully paid shares made available via the Stock Yield Enhancement Program.

Investor A, having found a source to borrow the shares , executes a short sale transaction on trade date, or “T” . 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, Investor 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 affected if needed. These borrowed shares provide Investor A’s broker with the necessary inventory to deliver onward to settle the short sales .

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 Investor’s account, thereby reducing or eliminating the short position.

In exchange for Investor A selling the borrowed shares, the cash received from selling the shares is used as collateral on Investor A’s borrowed shares.

Investor 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 stocks.

Any dividend earned during the term of the stock borrow will be paid to the borrower (Investor B) who holds the borrowed shares. The Lender of the Shares (Investor C) will be paid an equivalent cash amount by the Short Seller (Investor A) in what is called Payment in Lieu of Dividends.

Please note short selling is generally considered a high-risk strategy and should only be undertaken by experienced investors who understand the potential risks involved.

2 thoughts on “Mechanics of a Short Sale”

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