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Markets Media Online: Securities Lending Faces Scrutiny

August 19th, 2010

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Two years after the Securities and Exchange Commission took unprecedented steps to curb abusive naked short selling, the securities lending business and hedge funds are still feeling the after affects.

Many blamed speculative short sellers for much of the financial crisis, particularly so-called naked shorts, in which the seller does not borrow the stock to cover the short position.

The SEC requires that requires that broker-dealers locate an entity that the broker reasonably believes can deliver the shares within three days after the trade. In addition, the recently passed financial reform legislation includes stringent new reporting and disclosure requirements for all short sales.

“Activity will likely increase in the highly lucrative securities lending business, but so will transparency in this currently still opaque corner of the financial markets,” Sol Zlotchenko, chief technology officer at Paladyne Systems, told Markets Media.

The changes will fall particularly heavily on hedge funds, many of which make considerable use of shorting in their investment strategies. Hedge funds face skyrocketing borrow costs on securities transactions and depending on the strategy these costs can represent their largest portfolio expense.

Hedge funds execute their short positions through their prime brokers, which borrow the stock from large, institutional buy-and-hold investors such as pension funds and insurance companies. The prime brokers pay these institutions a premium, then assess their hedge fund clients a daily charge for financing these short positions.

Daily charges can add up quickly for a hedge fund, hitting their profits directly. Brokers sometimes change their rates without warning after a hedge fund has established its short position.  “We’re seeing an increase in adding additional prime broker relationships in order to seek out the lowest lending rates,” Vince Cutaia, equity trader at Conifer Securities, told Markets Media. “In addition there are some 3rd party firms offering to ensure you are getting the best rate on your locates and charging a percentage fee on the savings. All these services can be helpful to the Fund Manager but it is also time consuming and requires additional record keeping for all the locates and the associated lending rates.”

Charges can vary widely, depending on a variety of factors, such as how difficult and expensive it is for the broker to borrow a particular stock. Institutions generally charge brokers a considerable premium for less-liquid securities with a smaller float, called hard-to-borrow stocks.

“The locate charges are now a key part of the decision making in short selling. Excessive rates have had an affect on the investment process as charges can outweigh the profit potential. Many short ideas are now played via the option market even though the ‘hard to borrow’ or ‘excessive lending rate’ is already priced into the option premiums,” says Conifer’s Cutaia.

Individual relationships among brokers, institutions and global custodians often determine pricing and whether a prime broker can source the stock at all. Another factor can be the individual hedge fund’s relationship with the prime broker—small and mid-size funds with weaker credit and a less-lucrative stream of business may pay more.

Paladyne Systems, a technology provider for the hedge fund industry, is rolling out a specialized module, Short Availability Manager, that helps hedge funds cope with the new reporting requirements, locate the stocks they need to borrow, and compare pricing among brokers for maintaining short positions. “The key is helping users manage their locate processes and borrow costs in a transparent manner,” Zlotchenko said.

Short Availability Manager helps hedge funds locate stocks for borrowing, compare rates simultaneously among multiple brokers, and keep up with pricing changes, helping to manage costs through transparency and automation.

“The Short Availability Manager automates tracking of short positions for the fund’s own risk management, valuation, auditing and accounting, as well as for regulatory compliance and reporting,” Zlotchenko said. “Potentially, a hedge fund could save up to 10 to 20 basis points on their fees if they are able to manage borrow costs efficiently.”

While a few other short selling applications are currently on the market, they are either not integrated into a comprehensive portfolio management solution or lack some of Short Availability Manager functionality. “All hedge funds eventually will need a system of this type to handle their obligations under the new regulations,” Zlotchenko said, noting that leading prime brokers have agreed to electronically connect with the system.