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Shorting \'makes billions\' for groups

Date: Friday, July 18, 2008
Author: Deborah Brewster, Financial Times

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Conservative fund management firms and custody banks are making billions of dollars from short-selling by lending stocks to facilitate such trades in exchange for lucrative fees.

Even as short-sellers attract blame for driving big falls in financial stocks, financial services firms - including those targeted by short-sellers - are profiting from the investing strategy.

US prime brokerage firms, most of which are owned by big Wall St banks, will reap revenue of $11bn (5.5bn) this year, according to a recent study by Tabb Group, a research business.

Prime brokerage units provide services to hedge funds. They do not reveal their financial results, but executives who work for the units say they make most of their money from lending to short-sellers.

Fund management companies gain the lion's share of fees derived from lending the shares, and also the bulk of profits from reinvesting the collateral which short-sellers must provide them.

Short-sellers profit by borrowing shares, then selling the shares in the expectation the price will fall. When the price drops, they buy them back, and pocket the difference.

In order to sell short, they first borrow money from prime brokerage firms to fund the deal. They then borrow the shares, which are typically provided by big fund firms such as Fidelity, Oppenheimer and American Funds, for a fee.

The shares are usually passed to a custody bank, such as BNY Mellon or State Street, which also takes a small fee. The custody bank then passes the shares on to the prime brokerage which delivers them to the short-seller, after also taking a small charge.

A short-seller typically pays fees of 25-50 basis points in total, for a stock which is easy to borrow. The cost can rise to a couple of per cent if the stock is hard to locate.

However, the fees comprise less than half the total revenue. The fund firms and custody banks reinvest the collateral which the short-seller has put up, and that is more lucrative, at present generating twice the fee revenue, according to senior executives in the stock lending industry.

Traditional fund management companies, the underlying owners of the shares, get the most revenue from the chain of transactions, typically taking up to 90 per cent of the total in fees and reinvestment income.

These institutional investors, such as mutual funds and pension funds, which are frequently in an adversarial position towards short-sellers, thus earn billions of dollars from the practice.

Some custody banks have seen huge growth in their stock lending business.

State Street generated $303m in fees from its stock lending business in the first quarter of this year, which was a rise of more than 200 per cent on the same quarter last year.