An old world for Stock Borrowing and Lending

The announcement of the ESMA industry consultation relating to this year’s implementation of new regulations for the revision of the markets for short selling, including stock borrowing and lending can only be welcomed. However, it’s really ironic that the thrust of the concerns around stock borrowing and lending appear to me to be an admission that the stock borrowing and lending structure in the UK circa 1985 actually worked extraordinarily well. The new regulations focus on areas of loss of control and the problems of an open market allowing a virtual market free-for-all, which has let all types of organisations on the buy and sell side, borrow whatever stock they want, for any period of time and for any purpose.

Not surprisingly, in the high tech world of global securities markets, this stock borrowing free-for-all has opened the floodgates for market abuse. Organisations and individual traders can create huge short market strategies, using any number of bespoke OTC products (that fly under the radar of the regulator’s and the bank’s control mechanisms) to cause mayhem in the global markets. This mayhem is often mistaken for simply short selling but it is far more complicated than that.

There is nothing wrong with selling short, but who is allowed and what privileges they should have, must be called into question.

In 1985 the only organisations in the UK market that were allowed to go short were Jobbers (we now call them market makers). Jobbers were mainly family owned partnerships that were capitalised to a fraction of current market makers (now owned by Banks). The restriction of a small balance sheet meant that Jobbers managed carefully both long and short positions. This meant, we had a self-regulated market, based on the balance sheet of those that were allowed to play the short game. Jobbers were allowed to sell short by the regulator (the London Stock Exchange in those days).

Stock borrowing was a privilege given only to Stock Jobbers, for providing liquidity into a quote driven market but also to provide them with the capability to settle short Bear trades with buyers (This is where settlement liquidity allows investors to get their bargains settled on the date expected).

Stock borrowing was regulated by the Bank of England, who on any day knew which company was selling short and by how much and who was lending for what duration. All the stock borrowing and lending agreements were standard, under Bank of England control.

So in 1985 stock borrowing and lending in the UK was highly and closely regulated and the rights of the beneficial owners of the stock legally secure. It was a part of the business that was rewarding for all parties concerned and it worked wonderfully well. Why then change it?

Post ‘Big Bang’ the Banks now owning the Jobbers (Market Makers) wanted the cartel, as they called it, of Money Brokers, who were regulated by the Bank of England and administered the loans on an agency basis, broken up. This happened mainly through the demands of the USA Banks who wanted a similar arrangement, as in the States. This was the start of the free-for-all and the calamity that has now been created in the market. Now I know that it was all done for the best intentions but today one can see in the instigation of this new legislation, where answers can be found from the set up in the UK in 1985.

Stock borrowing and lending issues will also be discussed at the 22nd February Short Selling debate where Frank Field MP and Lord Vinson will be joining the panel.