January 30, 2019

Short-Term Borrowing

Half the volume in the stock market is short – borrowed. Why?

It’s the more remarkable because stocks since late December have delivered an epic momentum rebound. A 15% gain is a good year. Half the sectors in the market were up 15% in just the last 25 trading days.

Yet amid the stampede from the depths of the December correction, short volume, the amount of daily trading on borrowed shares, rose rather than fell, and remains 48%.  That means if daily dollar-volume is $250 billion, $120 billion is borrowed stock.

What difference does it make? We’ve written before that the stock market now has characteristics of a credit market.  That is, if lending is responsible for half the volume, the market depends on short-term loans rather than long-term investment.

And share-borrowing, credit, will give the market a false appearance of liquidity.

Think about the sudden and massive December declines that included the worst-ever points-loss for the Dow Jones Industrial Average.  Was that a liquidity problem? Does a V-shaped recovery signal a liquidity problem?

Before the Dodd-Frank financial legislation, large banks might carry a supply of shares to meet the needs of customers, especially stocks covered by equity research.

With rigid value-at-risk regulations now, banks don’t hold inventory.  The supply chain for the stock market has shifted to proprietary fast traders, which don’t carry inventory either. They borrow it.

We define liquidity as the number of shares that can be traded before the price changes.  Prior to electronic markets, trade-sizes were ten times larger than today.  The mean trade-size the last five days was 181 shares, or about $13,500 against an average market price of $74.61.

But a few liquid stocks skew the average.  AAPL’s liquidity is over $23,000, its average trade-size. WMT is the average, about $13,000. GIS is half that, about $6,800.

AAPL is also 57% short – over half its liquidity is borrowed.  And AAPL is used as collateral by 270 Exchange-Traded Funds (ETFs). Related?

(Side note: Why would AAPL be used more than other stocks in an index if ETFs are tracking an index? Because ETFs only use a sample, often the biggest stocks that are liquid and easy to borrow.)

These three elements – fast traders, high borrowing levels, ETFs – are intertwined and they create risks of inflation and deflation in stocks that bear no correlation to fundamentals.

The market, as we’ve said before, always reflects its primary purposes. If the parties supplying the market with shares are borrowing them, they have an economic interest that will compete with the objectives of those buying shares as an equity investment.

Second, borrowing is a back-office brokerage function. With massive short-term securities lending, the back office becomes as important as the cash equities desk. And it’s a loan business, a credit market (a point made by the insightful academics comprising the Bogan family).

And ETFs? If you want to know how they work, read our white paper. ETFs are not pooled investments. They are collateralized stock substitutes. Derivatives.

Collateral is something you find in a credit market. ETF collateralization, the wholesale market where ETF shares are created and redeemed, is a staggering $400 billion per month in US equities, says the Investment Company Institute.

It’s cheap and easy for brokers to borrow the shares of a basket of stocks and supply them as collateral to the Blackrocks of the world (does Blackrock then loan them out, perpetuating the cycle?) for the right to create and sell ETF shares (or provide them to a hedge-fund customer wanting to short the whole Technology sector).

And how about the reverse? Brokers can borrow ETF shares and return them to Blackrock to receive collateral – stocks and/or cash that Blackrock puts in the redemption basket to offer in-kind for ETF shares.

These are the mechanics of the stock market.  It works well if there’s little volatility – much like the short-term commercial paper market that froze catastrophically during the financial crisis.

We are not predicting doom. We are highlighting structural risks investors and public companies should understand. The stock market depends for prices and liquidity on short-term borrowing. In periods of volatility, that dependency will amplify moves.

In extreme cases, it’s possible the stock market could seize up not through investor panic but because short-term borrowing may freeze.

How might we see that risk? Behavioral volatility. When the movement of money becomes frantic behind prices and volume where only a few firms like ours can see it, market volatility tends to follow (as Sept 2018 behaviors presaged October declines).

Currently, behavioral volatility is muted ahead of the Fed meeting concluding today, loads of earnings, and jobs data Friday. It can change on a dime.

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