Insider Trading And The Cost Of Borrowing Shares

At the start of this year, while COVID-19 was beginning to reshape the world, a number of US senators became embroiled in scandal.

During the 2020 Congressional insider trading scandal, several US senators sold large quantities of shares prior to the market crash, allegedly using knowledge given to them at a closed senate meeting. The investigation is ongoing.

These allegations are particularly heinous, as the trading came at time when the US government was largely downplaying the seriousness of the pandemic. The trading activity seemed to go against the message being sent to the American people.

Prior to the 2012 STOCK Act, which prohibited using non-public information for private profit, insider trading was not uncommon for high-ranking members of the US government. A 2019 study showed politicians outperforming the market by 20% from 2004 to 2010, with high ranking Republicans outperforming by 35%. Following the introduction of the STOCK Act, the investment performance of politicians started to look similar to that of retail investors.

In developed share markets, the regulator keeps an eye out for unusual transactions. In NZ, a few cases pop up, such as one last year. The infrequency of such cases shows the FMA is doing a good job ensuring the public has trust in our stock markets.

Analysing the data implies some degree of insider trading in global markets, if you know what to look for. The cost of borrowing shares is one indicator.

Borrowing shares is an important part of short-selling, a method by which you can bet against a stock. In essence, short-selling involves selling a share today and buying it at a later date. This requires borrowing the shares from another investor, selling them at today's price, then paying the original owner at the market price in the future.

The borrowing cost incurred is a fee paid to the owner of the shares. These fees are determined largely by demand, or how many investors want to borrow that particular stock, how many shares they want to borrow and how quickly they want to borrow them.

If you had information not yet known to the public which, when released, would cause a company's share price to drop, short-selling would be the perfect way to take advantage of this. You could sell some borrowed shares before the announcement, while paying the lower price back to the share lender after the fact.

An increase in short-selling leads to an increase in borrowing costs for the company's shares. Not only has this been observed in global share markets, Dimensional research shows shares with high borrowing costs tend to underperform their peers over the short-term. It seems some investors are benefitting from information before it is made public and included into the share price.

Dimensional incorporates this research into their portfolio strategies by screening borrowing costs of shares. They avoid the purchase of shares with high borrowing costs in the short-term in order to provide higher expected returns to clients.

I have included below a short piece by Dimensional, including a link to the research regarding this topic.


Securities Lending Fees as a Short-Term Driver of Stock Returns

Securities lending involves the owner of a security (the lender) temporarily transferring ownership of the security to an investor (the borrower) in return for compensation. Traditionally, the value added from securities lending comes from the revenue generated from the fees lenders receive from borrowers. Dimensional has engaged in securities lending for many years in its efforts to enhance returns for fund shareholders. Research by Dimensional shows that market participants may be able to further enhance their investment outcomes by using information from prices in securities lending markets to identify short-term differences in expected returns across stocks.

We examine the informational content embedded in securities lending markets by testing the relation between the price to borrow stocks, or borrowing fees, and subsequent stock performance. Using data from 14 global securities lending markets1 for 2011-2018, we find that stocks with high borrowing fees tend to reliably underperform stocks not on loan over the next several days, and that this relation is more pronounced within small cap stocks.

High fee stocks that remain high fee one year later tend to drive this underperformance. Our research shows, however, that the persistence of high fees is not systematically predictable. While the relative magnitude of borrowing fees and borrowing utilization contains some information about the likelihood of high fees to persist, their predictive power is not sufficient to reliably identify which high fee stocks will remain in that group over time.

To incorporate these research insights into a robust investment process, we need to carefully balance the tradeoffs between expected return, revenue from lending activities, diversification, turnover, and trading costs. Our findings suggest that turnover and costs can be potentially high if buy and sell decisions are triggered by stocks crossing frequently the high fee threshold. Instead, we believe that an efficient approach to incorporate the information in borrowing fees into a real-world investment process is to consistently exclude from additional purchase small cap stocks with high borrowing fees.

View the research on SSRN

1 The following countries are included in the analysis: Australia, Canada, China, France, Germany, Hong Kong, Japan, Korea, Malaysia, Singapore, Sweden, Thailand, Turkey, and United States.