From the desk of Roy Zimmerhansl,
Practice Lead, Pierpoint Financial
On top of everything else this year, I’ve seen a series of stories presaging the demise of short selling - not great for securities lenders. These predictions are not due to any concerns over ethics, vulture tactics, allegations of market manipulation or regulatory impetus. None of these, just plain old Profit and Loss for short-sellers.
Why Fewer Short Sellers?
Hardly a surprise that it has been a challenging period for anyone with a short position. Take a look at the S&P 500 – from a low on 23 March of 2,237 it now stands at 3,699 – a rise of over 65%! The pan-European Stoxx 600 index had its best-ever month in November rising 13.73% for the month; the Nikkei traded at 29-year highs while the MSCI World Index jumped more than 12.5% for the month. South Korea’s KOSPI has set all-time highs, yet short selling is still banned until March 2021 – don’t get me started again on that situation.
The following chart is from a ValueWalk.com article referencing an investor letter penned by Chris Brown, who runs Aristides Capital. The letter addressed the challenges of being a short seller in the prevailing market conditions that I have described above, some of which are taken from Mr Brown’s letter.
This is a pretty grim chart if you are in the securities lending business. Of course, as always, you need to look through the data and apply other information. There is some context that I would like to overlay on this bleak picture.
Some Background
At the 2008 peak, banks were doing a lot of proprietary trading. As regulators have made it more difficult, expensive or outright disallowed, the absence of prop trading from banks is the single biggest issue that has reduced short-selling activity, particularly in the large-cap stocks.
Leverage has dropped off dramatically from 2008 peaks with the elimination of bank Prop Trading leverage as well as hedge funds going from 3X in 2008 to around 1X currently.
Since Q3 2007, prime brokers have increasingly ’internalised‘ short-covering – matching client longs and shorts without needing to make an exchange transaction or borrow securities externally. This masks a meaningful degree of short selling, and that has influenced the chart and lenders’ revenues.
Short-sellers also have more alternatives for short exposure with an increasing number of equity options contracts, inverse ETFs, and the spread of swap execution platforms joining ‘Contract for Difference’ (CFDs), the weapon of choice for many in earlier years. I would direct people to our recent podcast with Lynden Howie of Cantor Fitzgerald Europe who described the growth of Synthetic Prime Brokerage over the past 20 years. There is a subtlety here that sometimes gets overlooked – the provider of the swap contract will typically hedge their position. Ideally, that is part of the internalisation process, or as Lynden describes in the podcast, they transact with another investment bank synthetically, but there is residual spinoff activity that seeps into the conventional securities lending market.
At the highest level, there are two types of equity short sellers – those that short as part of a trading strategy (arbitrage, hedged, momentum, HFT, etc.) and activist investors. Everything so far has largely concentrated on trading-related activity and let me make one final point before moving on to activists.
According to the latest hedge fund performance by strategy from Aurum, shown in the chart below, the best-performing strategy YTD is Equity Sector Long/Short funds. It is likely that the funds reporting are more long-biased than their historical positions, and they have benefitted from such positioning this year. Asian L/S, in particular, is performing well +17.15% and that suggests long-bias, taking advantage of the market records I described earlier.
Activist investors can be either long investors that agitate for change and benefit from price rises or short traders that increasingly generate public campaigns identifying company-specific issues such as questionable accounting through to outright fraud. I’m not sure that the number of campaigns has been increasing or whether they are getting more attention, with greater coverage and recognition of their activity. Either way, this group is becoming more prominent and high profile, and there appear to be more firms generating campaigns.
Aside from this last point on activists, which can eventually lead to high-fee ‘specials’, I’ve not presented a lot of good news for securities lenders so far. However, given that to be a lender, one must also be an investor, rising markets are good for them overall, even if lending revenues drop.
Stock Market Outlook
Will markets continue to rise? Most of what I read suggests markets will keep going up, given the COVID-19 vaccines just about to be rolled out, continued loose monetary policy from most governments and all the magic faerie dust flying around the markets.
I’m not an investment adviser, so don’t have a view on market direction that I will share with you, but let me observe that the VIX is at its lowest level since February, just before the crash occurred. Additionally, we are at a historically low put-to-call ratio as measured by CBOE Equity Options volumes – a measure of investor comfort (complacency???). Finally, the CNN Fear & Greed Index is currently at the “Extreme Greed” rating.
Hmmm … Just in case you are worried, you can always read my blog post “5 things lenders should do to prepare for another crash”.
Some Perspective
OK, I’m looking for some positives that don’t require a market crash. This is the best I can do at the moment.
First, short selling and securities lending are spreading throughout the world. More markets, more participants, more activity all equal more opportunity. The US is the biggest market and probably will be for as long as I’m around, but who knows. Recent moves by China have given rise to optimism for the future of securities lending there. I have been saying for some time that demonstrable progress in China will force India to reconsider its closed stance to non-resident short-selling activity. If China continues towards more open access, India will stand alone among[AG1] the world’s largest equity markets as discriminating against short-selling without borders. If you look at examples such as Saudi Arabia, Philippines, Malaysia, Nigeria, Kenya and other markets that are at varying degrees of development, the spreading ain’t done yet.
Second, collateral transformation has generated revenue for fixed income lenders and will continue to do so as Uncleared Margin Rules hit subsequent phases and capture the biggest universe by number. The need for high-quality collateral is a material and persistent change.
Third, markets ebb and flow. While I don’t know when the inexorable upward trend will change direction or whether markets will experience extended periods of volatility, we know turbulence will happen again, and revenues can recover.
Ultimately, to paraphrase Mark Twain, the rumours of the death of short selling are greatly exaggerated.
However…
The reality is that irrespective of revenue highs and lows, I continue with my firmly held opinion that the real need for change is to reduce the cost and bulkiness of the operating infrastructure that we need to run the securities lending business. Efficiency improvement and lower expenses will improve profitability, whether volumes are higher or lower and arguably will enable new participants to enter the market and increase trading demand.
Last week was the ISLA Showcase focused on the Common Domain Model (CDM). This event provided a hopeful and practical example of a real transaction and the benefits that a CDM could bring to the market. We feel strongly enough about this need that we have made it a central tenet of our consulting business going forward.
Join our next #SecuritiesLendingLive with Pierpoint tomorrow at 10 am GMT where we will be focusing on CDM. My partners and I will be talking CDM and we are joined by our collaboration partner Julian Eyre. Viewers will be able to watch the participation, and if you access via LinkedIn, you will be able to ask questions and add your views via the Comments area.
It is available on LinkedIn, YouTube and Facebook with LinkedIn the best venue for interaction.
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