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The inner workings of the stock market
- A trade is agreed upon on day 0.
- Money is instantly deducted from the buyer's account, and goes into his broker's account so that it can execute the trade for its client.
- The broker has to make a margin deposit with the exchange's clearing corporation, which is the middleman and guarantor of the trade. More details on this below.
- On day 1, the broker moves the funds into a dedicated bank account from which the payment will be sent to the seller's bank account.
- On day 2, settlement takes place. The funds are sent to the seller's broker's bank account, and the buyer's broker receives the assets purchased in its depository. Depositories are central entities where assets are held. You can think of them like a bank for stocks/options/etc.
- The broker will transfer the stock received to the buyer's (segregated) account.
How a naked short sale works
Short sales are usually accomplished through equity loans. The short-seller borrows shares from an equity lender which he delivers to the buyer. This debt of shares to the lender gives him short exposure going forward. But there is another way to create the same exposure: by failing to deliver the shares. If the short-seller delivers nothing to the buyer, thereby incurring a debt of shares to the buyer, this also gives him short exposure going forward. This alternative moves the risk that the short-seller does not repay his debt from the equity lender to the buyer, but just as equity lenders have a mechanism for ensuring performance, i.e. collateral, so does the buyer. The clearing corporation intermediating the trade takes margin and marks it to market, thereby defending buyers against their sellers’ non-performance. If equity loans are expensive, unavailable, or unreliable, as research shows they can be (e.g. D’Avolio, 2002, Geczy, Musto and Reed, 2002, Jones and Lamont, 2002, Lamont 2004) then this alternative appears desirable, to short sellers if not to buyers. But considering the market rules that bind short sales to equity loans, how is it feasible?
The answer, we show, lies in the special access to delivery fails that option market-makers enjoy. Traders are generally obliged to locate shares to borrow before shorting, but those engaged in bona-fide hedging of market-making activity are exempt from this requirement. So unlike traders in general, a market maker can short sell without having located shares to borrow. If he does not locate shares to borrow then he fails to deliver, someone on the other side fails to receive, and therefore retains the purchase price, and the clearing corporation starts taking margin. While it lasts, this arrangement is effectively an equity loan from the buyer to the seller at a zero rebate. But whether it lasts depends on the reaction of the trader being failed to. If a buyer does not get his shares then he can demand them, in which case a short-seller who failed is bought in: he must go buy the shares and hand them over. If that short-seller wants to maintain his short exposure he must short again, so this demand increases his shorting cost by this roundtrip transactions cost. Thus, the cost of failing to deliver is the cost of a zero-rebate equity loan plus the expected incidence of buy-in costs. If this incidence is low enough, then failing is a valuable alternative to borrowing the harder-to-borrow stocks. We show that the alternative to fail is valuable and key to the pricing and trading of options.
How the split could be squeezing the naked shorts
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