I am a dumb dumb about stocks.
January 29, 2021 8:23 AM   Subscribe

Can someone explain a specific part of the GameStop thing to me?

I am not a financial expert. I can balance my checking account every month and I have a retirement plan, and that's the extent of my financial "savvy". I haven't dug in too deeply to the GameStop thing because I mostly don't care, and I also don't get it, but in trying to grasp it at a high level, a question keeps popping up that I can't find an answer for.

I understand the theory of short selling, but what I don't understand is twofold:

- Who actually loans out the shares that people short with
- What is the incentive to loan those shares

For whatever reason, my tiny money brain can't wrap my head around, particularly, the latter of the two. I don't get what the benefit is for the loaner of shares in a short sale situation.

While I don't quite need crayon drawings on construction paper, it's close - can anyone give me a good layperson's explanation of those two parts of short selling?
posted by pdb to Work & Money (11 answers total) 3 users marked this as a favorite
Your brokerage lends out the shares you own, if you are holding them in what is called a "margin" account. A margin account allows you to buy and sell "on the margin" - i.e. using your share value as collateral for a loan from the broker.

On the other side, the broker is letting others "borrow" your shares for short sale. Their incentive to do that is that they charge the borrower interest on the loan - it isn't free. So staying short for a long time has a cost.

Conceptually, it's very much like the bank does with your regular currency.
posted by scolbath at 8:35 AM on January 29, 2021 [6 favorites]

I am far from an expert, but my understanding is that it's mostly the brokerage firms that handle these things, so they just borrow the shares from other customers (who are, in theory, planning on holding them long-term and have no immediate use for them). For a lot of companies, the shares are just "sitting there" and are easy to borrow ("ETB") so the brokerage firms make money through fees by allowing other customers to short them. If there is a shortage of stock and shares become hard to borrow ("HTB"), then people wanting to short sell will pay a fee to the people who own the shares in order to be able to short them.
posted by Betelgeuse at 8:35 AM on January 29, 2021

Best answer: Brokers - who hold shares on behalf of their actual owners - have a clause in their contracts allowing them to loan out your shares, though you can usually opt out of that without drama.

People who borrow your shares for the purposes of short-selling them pay a fee to your broker. Some brokers will even kick back a portion of that fee to you - in 2019 I got a small payment from ETrade because someone shorted some of the shares that I owned. It was like an extra free dividend.
posted by Hatashran at 8:37 AM on January 29, 2021

When you open a brokerage account, you sign a hypothication agreement which allows the brokerage firm at which you keep your account to loan out or hypothicate your stock. Generally, your stock is held by your broker in "street name" that is the name of the brokerage who then allocates those shares to you on their books. If you paid cash, 100% for the stock then the firm can only lend your stock with your permission and would likely pay you a small fee to do so. If you buy on margin, you generally get nothing for lending out your stock. The brokerage firm charges the short seller a fee to borrow the stock. The short seller offsets that fee by having a credit for the value of the short sale in their account. They get credit interest. When you buy on margin you pay interest. The brokerage firm marks up the interest charge to the borrower and reduces the interest rate to the credit balance.

It gets much more complicated with a stock that is "hard to borrow" like GME. First, before you can sell the stock short, you need a "locate" or your broker has to assure you they can borrow the stock on your behalf. There is margin involved too. If they cannot locate the stock to borrow you get bought in which happened to a lot of shorts in GME. Also, if the stock goes against a short (goes higher) just like a long there are margin requirements. If you cannot meet those reguirements, you get bought in. This is what is causing part of the upward spiral.

Add into that the options and it gets messier. You do not need a locate to buy a put. You can exercise a put creating a short without a locate. That is how you can get shorts like in GME that was 102% of the open interest or shares outstanding. But, the 2nd day after an exercise, you need a locate. Then either you find the locate or get bought in.

If you buy the stock for cash, you can refuse to lend it out too which creates less available stock for the shorts.

I think I may have failed at a lay person explanation, but there really is no easy explanation if you want to truly understand it.

Hatashran above has a good basic explanation.
posted by AugustWest at 8:43 AM on January 29, 2021

I found this explanation really helpful. As I understand it, the short seller is (usually) way more likely to take a bath on this arrangement than the broker.
posted by anderjen at 8:47 AM on January 29, 2021

Best answer: People have hit the specifics, but to zoom out: You pay someone to borrow their shares, same way you'd pay interest for a cash loan.

That's all--that's why they loan them to you. There's nothing complicated or fancy in the basic concept.
posted by mark k at 9:19 AM on January 29, 2021 [3 favorites]

An example helps - a month ago let's pretend a share of Gamestop is 20$, but you think to yourself - that's too much and you think it's worth only worth 10$. Time to short it! So you find to a brokerage that owns this Gamestop stock on behalf of someone, and negotiate a short with the brokerage. They sells that Gamestop share for 20$ and you promise to buy that Gamestock share for them in the future, let's say a month, when you predict it will be less than 20$. That's the entering short.

The brokerage will charge you a fee that is basically like interest on the loaned stock just to enter and hold this short position. The price of this usually daily fee reflects how risky the brokerage thinks you are acting. The brokerage will also expect lots of collateral if this is considered especially risky. The fee on this 20$ stock might be 3 cents a day, or maybe its set to a whole dollar for the month of the short. Brokerages make huge money on this fee.

Exiting the short is where things can get dramatic. You hoped that the price of Gamestops's stock would go down - and let's pretend it went according to your plan and the price dropped from the 20$ the brokerage sold it at a month ago to 15$. You would pocket that difference, minus the 1$ fee, for 4$ profit. So for traditionally little risk to the brokerage lent out the stock, got it back and got a nice fee.

But what happens if the price doesn't go down - instead it goes up, to 30$. To exit the short you are obligated to buy the stock at 30$, and you eat that 10$ loss. The brokerage doesn't really care how much you have to pay for the Gamestop stock you owe - it still got it's fee, and it got the stock back that someone they represent thinks they 'own'. You care a lot about the current price though, that's why you have spent the last month telling everyone gamestock sucks and get all your smart buddies to agree.

You don't have to exit your short - when the term is up (if it ends) you can roll it over with new terms. If the brokerage thinks things are more volatile and risky then they will charge a higher fee, and now you can hold a new position that the Gamestop stock will fall below that original 20$, but now you are paying 2$ a month for that position. This can put intense pressure to exit the position the longer you hold or roll over the short - as it is generally tied back to your original position and original value.

What if you can't hold the position- you can't borrow enough assets to cover the collateral on your short? What happens if instead of 1 stock you built your short position up with 25 million of them, and the difference from the start of your short and the exit is now 125$ per stock? Or more? Now you are on the hook for billions of $! Then the brokerage gets your assets, and using those it can try to buy these stocks it has promised someone they represent, or give them the equivalent value (usually). Bad for you - you are bankrupt! Brokerage is still just fine - if they evaluated the risks correctly and the fees cover any losses.

But what happens if all your assets are also leveraged or the same asset class as all the other folks caught upside down on a short? What if the brokerage didn't get the risk level right, or loaned you those assets in the first place, or you are part of the same company? That's where we are today - a systemic crisis.

This is why there used to be lots rules about keeping banks, brokerages and hedge funds separate.
posted by zenon at 9:38 AM on January 29, 2021 [15 favorites]

Here's what I knew about it.

You can "short-sell" a stock you don't own, by "borrowing" the stock from your brokerage. For example, let's say you "know" stock GS will drop from 45 to 30 in the next... 14 days. So you put out this short order: short 100 GS shares at $44. The broker will go "borrow" 100 shares of GS from somewhere (his own portfolio, portfolio of his clients, or even other brokers) and "sell" them at $44. Now your broker just have to buy back 100 shares of GS at prices below $44 to make a profit. If it really falls to $30 by day 14, and he buys back the 100 shares at $30, you'd have made $14 per share, or $1400, minus fees and commissions (borrowing those shares ain't free).

But if the shares did NOT fall, but actually RISE in value, you will lose money, and depending on how quickly you recognize the problem, you can end up losing a LOT of money.

Here's a longer version from Wall Street Survivors, a trading sim.

(This is what happened to Ackman after he bet that Herbalife will go to zero a few years back. It didn't, and he lost millions on this, but that's another story.)

From what I heard, some amateur analysts on reddit figured out that a LOT of people are short-selling Gamestop stock (basically betting that Gamestop stock will fall) that the borrowed shares have exceeded the actual number of GS shares that are being publically traded. In other words, somebody will lose BIG if the prices actually rose (because not all of them can "buy back" shares fast enough to minimize their losses), and they figure it's some hedge fund managers. So they basically engineer a buy event (more like "let's screw the hedge funds" event) by rallying the small investors. This is known as a "short squeeze" play, which forces the short-sellers to scramble to find a reasonably priced stock to "pay back" the shares they borrowed to minimize their losses.

However, the question here is... is this "deliberate stock manipulation", which SEC frowns upon?

Heard that multiple brokerages such as TD AmeriTrade, and even Robinhood, which lets normal plebes buy stock, had suspended trading of Gamestop, AMC, and a few others being squeezed.

Which would make sense as brokerages have to scratch each other backs, rather than doing each other in.

But it is very likely that the brokerages and hedge fund managers will call for some sort of censorship claiming that sh*tposters has no right to manipulate the market with "meme stocks" postings.

And some have already done so, supposedly. Discord, a chat server community, had apparently banned WallStreetBets community server, who's a part of the Reddit squeeze play. And this was called into attention by none other than Elon Musk via a Tweet. But then, Elon Musk was known for being called before the SEC for his tweets, and was fined 40 million after claiming he'll take Tesla private by paying X per share. Discord claims the server was banned for failure to follow hateful and discriminatory content policy, not for the squeeze play. But other people call it "convenient timing that stinks".
posted by kschang at 11:34 AM on January 29, 2021

Note: I should clarify that I think the systemic issue is limited to the short seller/hedge fund market and their counter parties, because the 'stonk market' is much bigger than just this circus. This isn't a repeat of 2008, just another indication that no lessons were learned about how to contain risk.
posted by zenon at 11:40 AM on January 29, 2021

Just to clarify, some brokerages did start allowing these meme stocks to be traded, claiming their clearinghouse for the transactions, Apex, had both a financial and technical issue and it was resolved to mutual satisfaction to allow the resumption of trading. However, Robinhood is STILL restricting the meme stocks to 1 share per account, last I checked yesterday.
posted by kschang at 2:39 AM on January 30, 2021

Louis Rossmann has the best explanation of the whole thing AND updates on what really happened vs. what the reaction was (and let's just say Robinhood is playing "word weasel)
posted by kschang at 1:24 AM on January 31, 2021

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