Mechanics of a Short Sale

There is a pretty good presentation at Business Insider on the mechanics of a short sale. Link here. This is the first writeup I have come across on the mechanics of a trade that goes to a greater level of detail.

I have summarised the key points, re-phrased and re-organised it below for easier reading. There is potentially some mix-up in the use of DTC and NSCC. For example, when talking about buying and borrowing shares, in some slides DTC was the party, and in other slides NSCC was the party.

The Players

  1. When you buy a stock, you get a “securities entitlement” which is a legal claim against your broker.
  2. Your broker has a similar claim is against a stock clearing house called The Depository Trust Company (DTC) whose subsidiaries, the Depository Trust & Clearing Corporation and the National Securities Clearing Corporation (NSCC), are in charge of keeping track of stock sales and purchases. The stocks are held in custody accounts at the DTC.
  3. Your broker deals with the NSCC, a clearing house which has committed to ensure that all stock and funding obligations of all of its members (e.g. brokers) are discharged.

The Process

  1. On the 1st day after a trade is made, the NSCC nets trades against each member and tells DTC to note down the net position changes. This process is known as  continuous net settlement (CNS). When it comes time to settle on the 3rd day after the trade, the broker’s stock account at DTC is debited and a corresponding credit is issued to the purchasing member’s stock account at DTC.

The Short Selling Broker

  1. If a broker does not have enough shares to cover its sales, this situation is called “fail to deliver”. The buying broker can exercise a “buy in” right if it still wants the shares, and NSCC will then tell the other broker (the seller) that it has two more days to satisfy its obligation to acquire the shares in its account. This is called a “delivery obligation”.
  2. Usually what happens is that following a sale the short seller enters into an agreement with a current owner of the stock to acquire the current owner’s shares in return for an obligation to deliver shares back whenever the current owner demands.  The short seller can then deliver the acquired shares to the NSCC buyer in satisfaction of its delivery obligation.
  3. If a seller fails to deliver shares through NSCC on the third day after the trade, it has an ongoing and enforceable obligation to deliver the shares. The NSCC can go to court to force the seller to find the shares.

Stock Borrow Program

  1. If the seller fails to deliver on the 3rd day after the sale, the broker has to post some fraction of the stock’s current market value as collateral with the NSCC. If the stock price declines after the 3rd day, some or all of this collateral gets returned to the short seller’s broker. If the stock price rises, the NSCC debits the broker’s funds account for the additional margin.
  2. The DTC has the option of buying the stock itself, and deducting the cash account of the member that failed to deliver. If the broker has run out of cash, the DTC has an enforceable legal right to require the defaulting broker to deliver the shares.
  3. If the DTC can’t find a seller, it can use its Stock Borrow Program (SBP) to borrow from its members. Stocks held in custodial (cash) accounts are not available for borrowing, but those held in margin accounts are. Borrowable shares are used to make delivery to brokers with open positions (i.e. unmet purchase orders).
  4. When shares are lent out, the broker gives up title to those shares. In exchange, the broker gets a cash deposit equal to the current market value of the stock.
  5. The broker to whom the shares are lent now has title to the stock and all rights, e.g. it can sell the shares, vote on proxy issues, receive dividends or lend them out again through the NSCC’s stock borrowing program.
  6. The NSCC charges a fee to each broker whose failure to deliver requires the use of the SBP. The NSCC borrows the shares to meet the obligation.  It then returns the shares to the stock lender when it receives shares from the selling member, or when the shares become available for sale and the NSCC buys them and debits the purchase price from the broker’s account.
  7. Upon receiving the shares back, the broker who lent the shares returns the cash deposit but keeps the interest proceeds. Brokers who have lent shares in the program can demand at any time during a trading day that they get their shares back.  The NSCC then has to initiate a buy-in or locate more shares that can be borrowed.

What if There are Not Enough Shares for Sale or for Borrowing?

  1. The short selling broker continues to have an open delivery obligation to NSCC and it doesn’t get paid for the sale until the shares are delivered.
  2. The broker for the buyer keeps the funds until the stock is delivered (i.e. credited to its account at the DTC).

What’s the Catch for Short Sellers?

  1. You have to post 102% of the current market price of the stock as collateral for the stock loan. Your collateral is marked to market.
  2. There is a counter-party risk that whoever lent you the shares (and has your collateral) can fold.

Anatomy of a Short Sale

  1. The buyer’s cash is held by the DTC until the stock is delivered
  2. The short seller uses that cash (which he cannot get until he delivers the stock to the buyer) as collateral to borrow temporarily from his broker. He then uses the cash he borrowed from his broker (including the additional 2%) as collateral to borrow stock from the lender.
  3. The short seller delivers the stock to the buyer and gets the cash from the buyer, which he uses to pay back the temporary loan from his broker.

Summary of a Normal Trade

  1. The buyer gives his broker cash or a promise to pay up later.
  2. The buyer’s broker either makes a market itself by netting out the transaction with other customers or it makes a cash deposit for the sale with the DTC.  This cash is held in its account until the stock is delivered.
  3. The seller instructs his broker to debit its account for the shares sold. The seller’s broker either makes a market itself by netting out the transaction with other customers or tells the NSCC to debit its account for the amount of the stock sold.

Summary of a Normal Short Sale

  1. The short seller tells his broker to initiate a sale of the stock. The buyer deposits cash with its broker, and the broker then makes a cash deposit with the DTC and instructs the NSCC to credit its account with the stock.
  2. The cash is held in its account until the security is delivered into its account. The short seller borrows against the cash deposit or fronts the cash itself to provide collateral to a current owner who is willing to lend the stock.
  3. The DTC account of the lender’s broker is debited and the DTC account of the seller’s broker is credited for the stock that the short seller borrowed. The NSCC then debits this stock from the short seller’s broker’s account and credits the buyer.
  4. At some point the stock lender asks for the stock back, and the short seller engages in the straight stock trade or shorts it again by borrowing more shares.
Summary of a Naked Short Sale
  1. A naked short occurs when the short seller does not intend to locate and borrow shares for delivery to the NSCC.
  2. When the NSCC tries to debit this stock from the short seller’s broker’s account and the broker doesn’t have enough stock in its account and doesn’t buy it or borrow it, the NSCC initiates its own stock borrow program or purchases the stock. It then credits the buyer with the purchase.
  3. If the broker for the short seller still doesn’t buy or borrow the stock, the NSCC charges the brokers cash account or claims the collateral.
  4. If not enough stock is available for purchase or borrowing, the DTC will tell the buyer that the security cannot be delivered and gives back the cash plus interest and an amount to make up for the rise in the price of the stock. As a result, no “phantom shares” are created.
  5. The buyer is not exposed to the counter-party risk of the short seller because the NSCC becomes the counter-party that will either deliver the stock or pay the cash equivalent result. The NSCC holds collateral from the short seller’s broker, who in turn holds collateral from the short seller.
  6. Naked short selling can create additional downward pressure on stocks, but more for the illiquid stocks.


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