Short selling often sounds mysterious, even controversial, but at its core, it's simply another way for investors to express a view on where prices are heading.
In practice, the process usually begins with a hedge fund deciding to short a particular stock.
The fund contacts its prime broker to arrange a borrow, asking how many shares are available and at what cost.
The prime broker then sources those shares typically from institutional investors, such as pension funds or asset managers who are willing to lend their holdings in exchange for a fee.
Once the borrow is secured, the hedge fund sells the borrowed shares into the market, hoping to buy them back later at a lower price.
Here's how the flow of a short sale works.
The institutional investor lends its stock to the prime broker, usually a large investment bank under a stock lending agreement and receives a fee in return.
The Prime Broker's stock loan desk then lends those shares to the hedge funds clients, which provides collateral, usually cash or eligible securities, plus an additional margin.
The hedge fund can now sell the borrowed shares into the market.
Normally settling on a T plus one or T plus two basis and short selling regulations may apply.
At that point, the buyer in the market becomes the new beneficial owner of the shares entitled to receive dividends and exercise voting rights.
When the hedge fund decides to close the position, the process simply reverses.
The hedge fund buys back the shares in the market again on a t plus one or T plus two basis, and delivers them to the prime broker.
The prime broker passes them back either to the original beneficial owner or re lends them to another client.
The institutional investor receives the shares back on account and the lending agreement is terminated.
If the hedge fund buys the shares back at a lower price than it sold them for, it makes a profit.
The difference between the short sale gain, less the borrowing and transaction costs.
From a legal perspective, stock loans are normally governed under standard market documentation, either a global Master Securities lending agreement, or in some cases ISDA or GMRA terms.
If you think of it in repo terms, stock lending is essentially the reverse repo leg Of a fixed income transaction.
You receive securities and you give cash rather than the other way around.
The institutional investor receives collateral from the prime broker and the prime broker in turn receives collateral from the hedge fund, always with a small margin to protect against price moves.
And of course, stock borrowing fees apply as well.
The level of stock borrow fees depends heavily on supply and demand.
The liquid, easy to borrow names, fees might be as low as 20 basis points per year.
But for specials, hard to borrow stocks that everyone wants to short, the cost can climb to several hundred basis points, sometimes 500 or more.
A stock becomes special when demand to borrow it.
Far exceeds available supply.
For example, if the company is in trouble or heavily involved in a merger arbitrage trade, if the borrow is difficult to find, the prime broker or the investor may require a term loan, say a 30 day commitment.
Even if the hedge fund covers its short early, it will still pay the full fee for the agreed term.
And what happens in case of dividend payments? When dividends are paid on the borrowed shares, the original investor still expects to receive them because the shares have been sold into the market.
The hedge fund short seller doesn't receive the dividend, but does have to make a synthetic cash dividend payment to the prime broker, which then passes it onto the original investor.
This ensures that the lender is made whole as if it had never lent the shares in the first place.
However, the short seller shouldn't be at a loss from this, since the stock price should fall by the size of the dividend when it's paid, reducing the repurchase price for the short seller.
When closing the position out.
The same principle applies to other corporate actions.
For example, if a stock split or rights issue occurs, the short seller must deliver equivalent economic value to the lender.
