What Drives Demand in Specials?
By Chris Benedict, Product Specialist & Senior Analyst, DataLend
SECURITIES LENDING is a transaction between a borrower and a lender where the lender agrees to loan their shares of a security to a borrower for a period of time. The borrower gives collateral to the lender for the life of the loan and also pays the lender for the use of the securities. On the surface the transaction appears simple enough, but there are many reasons why institutions borrow securities. In this article DataLend examines the reasons why firms borrow securities, and some of the factors that can drive demand and make a security trade “special.”
Directional shorting, or the belief that a company is temporarily overvalued in the cash market, is one of the most well-known examples of why firms borrow shares. A firm will temporarily borrow shares to execute a short sale with the intention of buying the shares back at a lower price. The “sell high, buy low” mentality has persisted in the blockchain and marijuana space over the last two years as investors feel the valuations in these industries may have gotten ahead of themselves.
Another major reason for securities lending is mergers and acquisitions activity. In most M&A deals, an investor will typically short the acquiring company and buy long the company being acquired. A recent example of this was Takeda Pharmaceuticals purchasing Shire PLC for $62 billion, the largest acquisition of a foreign company in Japan’s history. In late November 2018, the fees to borrow Takeda were averaging in a “GC,” or low fee to borrow, range. By early January this year, those fees had increased by 1,900% into the hot range, while utilization reached a peak of 88%. Once the deal had closed by mid-January, fees immediately dropped back down to their previous GC levels, while utilization plummeted to around 4% more recently. Takeda Pharmaceuticals alone generated $28.8 million in revenue for securities lenders last year.
Pairs trading is a strategy where two usually highly correlated companies in the same sector or industry appear to be temporarily mispriced. Traders will short the company that appears to be overvalued and buy long the company that may be undervalued. Classic examples of pairs trading include shorting Mastercard and buying Visa, or shorting Pepsi and buying Coca-Cola.
Statistical arbitrage trading, where a derivative such as an ETF may seem temporarily mispriced when compared to its underlying constituents, is another example. Traders may elect to short the ETF while going long the underlying constituents, or vice versa. Traders are able to glean incremental profits as the derivative and constituents trade in the cash market.
Similar to statistical arbitrage, cross-border arbitrage is still alive and well in today’s market, where traders compare the price of foreign companies trading on an international exchange in the form of a depositary receipt versus the price of the common shares trading on a local exchange. Due to temporary price discrepancies, traders can eke out small gains shorting one and going long the other. This is also the case with convertible bond arbitrage, where a trader may short the common shares and buy long the bond knowing they are protected from a short squeeze with the conversion option on the bond.
Other reasons to borrow securities may be operationally driven, such as temporarily borrowing securities to cover a fail to deliver, which could lead to steep fines, headline risk or worse in certain markets. Regulatory pressures, such as the need to borrow high-quality liquid assets (HQLAs) as collateral to pledge for other activities, can also drive demand. Seasonal event activities may be another reason to borrow equities.
ALL OF THE REASONS to borrow securities have one thing in common: cost. Borrowers need to compensate lenders for the temporary use of their securities. How much borrowers need to pay their lenders to access those securities is situational. Securities in high demand that command large fees to borrow are typically called “specials.”
Supply is a key component of determining whether or not a company will trade special. Even if a company is facing significant economic headwinds or operational challenges, if there is enough supply available for short sellers to borrow, it won’t necessarily trade special.
A good example of this was the intense selling pressure recently faced by Pacific Gas and Electric (PCG). In late 2018 it was alleged that PCG’s equipment may have accidentally caused the deadliest and most destructive wildfires in California’s history. These concerns, along with a very high debt load, a departing CEO, its removal from the S&P 500 index and subsequent filing for Chapter 11 bankruptcy in late January made this a very attractive and obvious short candidate.
Despite the bad news and the resulting brutal 86% drop in the stock’s price from November 2018 to mid-January this year, the security never traded above 250 bps in the securities finance market for that period. PCG’s utilization hit a peak of 24% around the time the company announced its Chapter 11 filing in late January and has since dropped back down to around 6% more recently. PCG never traded special because of the ample supply in the securities lending market: The total lendable supply is just short of 44 million shares, of which just under two million were out on loan recently.
Securities with low lendable supply are typically described as “hard to borrow” and are more prone to trading “special.” Lendable supply is ultimately dictated by beneficial owners, who decide whether or not to make their securities under management available for lending. Beneficial owners elect to make their shares available to lend primarily to capture additional alpha with relatively low risk. However, some beneficial owners require a “hurdle rate,” or minimum fee, before they will allow their securities to be lent out; unless that fee is met, the shares remain restricted.
Supply in the securities lending market can change or become “restricted,” or not available to lend, for a number of reasons. One common reason is that a beneficial owner decides to sell a position in its portfolio. When this happens, the lender must then recall those shares from the borrower in order to deliver them for the client’s sale in the cash market. The prime broker side must then try to locate the shares from another lender to keep its hedge fund client’s position intact. If the security is in demand and is heavily utilized, supply from agent lenders may be exhausted, forcing the borrower to source the security from another borrower, often at fees higher than the traditional lender-to-broker market.
Beneficial owners may also recall shares to ensure they have the ability to vote shares on a corporate action or board change. Ultimately, when supply is very low or is declining due to the reasons mentioned and the right catalyst presents itself in the form of poor earnings, corporate events, unexpected news or other factors, a security can very quickly command high fees to borrow.
Of course, available supply in the securities lending market can also increase. New issues through secondary offerings can increase supply. Expiry of the “lock-up” period after an initial public offering, allowing insiders to sell shares, may also increase supply as beneficial owners may purchase those shares and in turn lend them out. Finally, as shares trade in the cash markets, investors or beneficial owners not participating in securities lending may sell shares to entities that are, thus increasing available supply in the securities finance market.
TO FURTHER EXAMINE the relationship between supply and securities trading special, DataLend reviewed the universe of equities on loan in 2017 and 2018 globally and regionally to see if there were any differences in volume-weighted average fees by market capitalization. Some fairly significant differences emerged, as depicted in Figures 1 and 2.
FIGURE 1: VOLUME-WEIGHTED AVERAGE FEES BY MARKET CAP, GLOBAL EQUITIES, 2017 AND 2018
FIGURE 2: LENDER CONCENTRATION FOR TICKER TSLA ON A TYPICAL TRADING DAY IN 2019
As we can see for both 2017 and 2018, there is a clear delineation in the fees to borrow global mid versus small cap equities and again in small versus micro or nano cap equities. There is also a difference between the fees to borrow mega and large cap names, although less pronounced.
A similar pattern exists across equities from a regional perspective. For example, in the more thinly traded Asia markets, the various market cap fee bands appear to trade somewhat hotter than the overall global averages. In EMEA the pattern repeats itself, although the mega and large cap companies may have higher volume-weighted average fees than the rest of the world due to the busy corporate events season in the spring. Finally, in North America, the pattern is observed again with a more pronounced difference in fees to borrow small versus micro or nano cap equities. Securities such as Synergy Pharmaceuticals, Zion Oil and Gas, Riot Blockchain, NXT-ID, Net Element, DPW Holdings and others traded very special last year, generating millions of dollars in revenue while helping to push the fee averages in the North American micro and nano cap spaces for 2018 higher than in other regions.
Before the advent of securities finance trading and market data services, determining supply in the securities lending market was challenging and time consuming, involving many phone calls to various agent lenders trying to locate the desired securities, followed by negotiating various trade parameters. Now, with EquiLend’s NGT, borrowers can send needs lists to their counterparties with the click of a button. Lenders can send their entire list of available supply and desired rates to all of their counterparties just as easily.
From a market data perspective, the concentration histogram in DataLend’s Security Search screen is an excellent tool for viewing the depth and breadth of supply of a security in the securities lending marketplace, showing the number of firms lending the security, the number of borrowers borrowing the name and the number of firms with lendable inventory in the security (including those firms with inventory but not currently lending). Trending information can also show supply changes over time, from total lendable, which may increase or decline for the reasons previously mentioned, as well as demand statistics as borrowers initiate (or close out) short positions. These tools help making finding lendable supply— and anticipating what might trade “special”—easier than ever before.