Biggest short-selling players getting a pass

New York

IT'S in the air again, on Reddit, in Congress, in the C-suite: Hedge funds that get rich off short-selling are the enemy. The odd thing is, the biggest players in the game are getting a pass.

Those would be the asset managers, pension plans and sovereign wealth funds that provide the vast majority of securities used to take bearish positions. Without the likes of BlackRock Inc and State Street Corp, the California Public Employees' Retirement System and the Kuwait Investment Authority filling such an elemental role, investors such as Gabe Plotkin, whose Melvin Capital Management became a piñata for day traders in the GameStop Corp saga, wouldn't have shares to sell short.

"Anytime we short a stock, we locate a borrow," Mr Plotkin said on Feb 18 at the House Financial Services Committee hearing on the GameStop short squeeze.

As at mid-2020, some US$24 trillion of stocks and bonds were available for such borrowing, with US$1.2 trillion in shares - equal to a third of all hedge-fund assets - actually out on loan, according to the International Securities Lending Association.

Given the popular belief that short-sellers create unjustified losses in some stocks, why would shareholders want to supply the ammunition for attacks against their investments? By loaning out securities for a small fee plus interest, they can generate extra income that boosts returns. That's key in an industry where fund managers are paid to beat benchmarks and especially valuable in a world of low yields.

The trade-off is simple: For investors with large, diversified portfolios, a single stock plummeting under the weight of a short-selling campaign has little impact over the long run. And in the nearer term, the greater the number of aggregate bets against a stock - the so-called short interest - the higher the fee a lender can charge.

In the case of GameStop, short interest was unusually high and shares on loan were generating an annualised return of 25 per cent to 30 per cent, Ken Griffin testified at the Feb 18 hearing. Mr Griffin operates a market maker, Citadel Securities, as well as Citadel, one of the world's largest hedge funds.

Not everyone is comfortable with the inherent conflict. In December 2019, Japan's US$1.6 trillion Government Pension Investment Fund stopped lending its international stock holdings to short-sellers, calling the practice inconsistent with its responsibilities as a fiduciary. At the time, the decision cost GPIF about US$100 million a year in lost revenue.

There's a symbiotic relationship between hedge funds and the prime-brokerage units of Wall Street firms, much of it built on securities lending. Prime brokers act as intermediaries, sourcing stocks and bonds for borrowers who want to short them and facilitate the trades. According to DataLend, securities lending generated US$2.9 billion of broker-to-broker revenue in 2020, almost the same as in 2019.

Demand for short positions was already expected to drop as stock prices surged to all-time highs. Now, with the threat of retribution from the Reddit crowd, it may weaken even further. Mr Griffin said he has "no doubt" there'll be less short-selling as a consequence of the GameStop squeeze.

This could not only threaten the dealers who broker stock lending but also the holders who supply the securities and share in the revenue. They reaped US$7.7 billion globally in 2020, down from a record of almost US$10 billion in 2018, according to DataLend. Lending fees increased by 4.2 per cent on a year-over-year basis in February after the GameStop onslaught, DataLend says.

While securities lending accounted for US$652 million, or just 4 per cent, of BlackRock's revenue in the fourth quarter of 2020, there's little cost involved and the risks are low because borrowers have to put up collateral that equals or exceeds the value of the loan. At both BlackRock and State Street Corp, the second-largest custody bank, the value of securities on loan as at Dec 31 jumped at least 20 per cent from a year earlier, to US$352 billion and US$441 billion, respectively. BLOOMBERG