Securities Lending
Short selling requires borrowed shares, which brings us to securities lending: the mechanism that makes short selling possible and the enforcement framework for when borrowed shares are not returned on time.
How Securities Lending Works
- A securities lender (typically a custodian or institutional investor) lends shares to a borrower (typically a broker-dealer or hedge fund) for a fee
- The borrower posts collateral (usually cash or other securities) equal to or exceeding the value of the borrowed shares
- Securities lending facilitates short selling, settlement, and market making
Hard-to-Borrow Securities
- Securities with limited availability for borrowing due to high demand, low float, or heavy short interest
- Broker-dealers maintain easy-to-borrow and hard-to-borrow lists
- For hard-to-borrow securities, the firm must have a pre-borrow arrangement before effecting a short sale (a general locate is insufficient)
- Borrowing fees for hard-to-borrow securities are significantly higher than for easy-to-borrow securities
Exam Tip: Gotchas
- For hard-to-borrow securities, a general "locate" is not enough. The firm must have a pre-borrow arrangement in place before executing the short sale.
Fail to Deliver (FTD)
- A fail to deliver occurs when the selling party does not deliver securities to the buying party by the settlement date
- FTDs can result from:
- Naked short selling
- Operational errors
- Inability to locate shares
Close-Out Requirements (Regulation SHO Rule 204)
If a participant has a fail-to-deliver position, it must close out the position by purchasing or borrowing securities of like kind and quantity:
| Type of Fail | Close-Out Deadline |
|---|---|
| Short sale fails | By the beginning of regular trading hours on T+2 (one settlement day after T+1 settlement) |
| Long sale fails / bona fide market-maker fails | By the beginning of regular trading hours on T+4 (three settlement days after T+1 settlement) |
Exam Tip: Gotchas
- Short sale fails-to-deliver (FTDs) must be closed out by T+2; long sale FTDs get until T+4. The shorter deadline for short sales reflects the higher regulatory concern around failures from short selling.
The Penalty Box (Pre-Borrow Requirement)
- If a participant fails to close out a fail to deliver (FTD) by the required date, a stricter restriction kicks in
- The participant and any broker-dealer for which it clears may not accept a short sale order in that security without first borrowing or arranging to borrow the security
- This means a simple "locate" is no longer sufficient; the firm must actually pre-borrow
- The restriction remains until the FTD is closed out
Think of it this way: The penalty box works like a probation system. Once a firm fails to clean up its fail to deliver on time, the rules get stricter: a simple "locate" (knowing where shares are available) is no longer enough. The firm must actually borrow or arrange to borrow the shares before accepting any new short sale orders in that security.
Exam Tip: Gotchas
- The penalty box applies to the clearing participant AND every broker-dealer that clears through it. A single firm's failure can restrict short selling for all its correspondent firms in that security.
- A "locate" is NOT sufficient once in the penalty box. The firm must actually borrow or pre-borrow the shares.
Anti-Sham Close-Outs (Rule 204(f))
- A purchase or borrow does not qualify as a close-out if the participant knows or has reason to know the securities will not actually be delivered
- Prevents "sham" close-outs designed to reset the clock on fail-to-deliver (FTD) obligations
- Example: Buying shares from someone you know also can't deliver them is not a valid close-out
Exam Tip: Gotchas
- A purchase or borrow is not a valid close-out if the participant knows the securities will not actually be delivered. This prevents firms from doing "sham" transactions just to reset the clock on their fail-to-deliver (FTD) obligations.