3.2 Short selling, leverage and prime brokerage

Two tools set hedge funds apart from most traditional funds: short selling, which lets a fund profit when a price falls, and leverage, which lets it hold more positions than its own capital would pay for. Lesson 2.1 showed how these create gross and net exposure. This lesson looks at the plumbing behind them.

Both tools depend on borrowing, shares in one case and money in the other, and both are usually provided by the same firm: the prime broker. You will meet these terms in margin reports, financing agreements and investor questions. The examples are fictional and illustrative.

How a short sale works

A short sale is the sale of shares the fund does not own. It works in four steps:

1. Borrow. The fund borrows the shares, usually arranged through its prime broker, which sources them from its own inventory or from lenders such as other funds and institutions.
2. Sell. The fund sells the borrowed shares in the market and receives the cash. That cash is usually held as collateral for the loan.
3. Buy back. Later, the fund buys the same number of shares in the market. This is called covering the short.
4. Return. The fund returns the shares to the lender, closing the loan.

If the price fell between steps 2 and 3, the fund keeps the difference as a profit. If it rose, the fund loses the difference. While the short is open, the fund also has to pay the lender any dividends the company pays, since the lender would otherwise have received them.

The following example is illustrative. The Kessling Harbor Equity Long/Short Fund expects a fictional company, Brightwater Robotics, to disappoint investors. It shorts 10,000 shares at $50.00, receiving $500,000. It pays a borrow fee of 2% a year on the value of the shares borrowed and holds the position for six months.

The gain is ($50.00 − $40.00) × 10,000 = $100,000; the first loss is ($65.00 − $50.00) × 10,000 = $150,000. For simplicity the fee is worked out on the starting value; in practice it is commonly charged daily on the current value of the borrowed shares.

The risks of being short

Losses are theoretically unlimited. When you buy a share, the most you can lose is what you paid, because the price cannot go below zero. When you short, there is no ceiling on how high the price can go. In the table above, a doubling of the price loses the fund more than the entire $500,000 it received from the sale.

Borrow costs vary. Most large, widely held stocks are cheap to borrow. Stocks that are scarce, or that many investors want to short, are hard to borrow, and their borrow fee can be much higher. A high fee can wipe out the profit on an otherwise correct view.

The lender can recall the shares. Securities loans can usually be ended at short notice. If the lender recalls the shares and the prime broker cannot find replacements, the fund may be forced to buy back and close the short, whether or not the price is favorable.

Short squeezes. A short squeeze happens when a rising price forces short sellers to buy back to limit their losses or meet margin calls. Their buying pushes the price higher, which forces more short sellers to buy, and so on. Squeezes are most dangerous in heavily shorted stocks.

Leverage: margin and derivatives

Leverage means controlling positions worth more than the fund's own capital. Hedge funds get it in two main ways:

• Margin borrowing. The prime broker lends the fund cash to buy securities, secured on the fund's assets. The fund must keep a minimum amount of its own capital, called margin, against its positions.
• Derivatives. Instruments such as futures, options and swaps give exposure to a large amount of an asset for a much smaller upfront payment. A total return swap, for example, lets a fund receive the returns on a basket of stocks without buying them, in exchange for paying a financing charge.

Leverage magnifies gains and losses alike, because borrowed money has to be repaid in full whatever happens to the positions. Illustratively, compare two funds, each with $10m of capital, when their long positions fall 10%:

Financing costs are ignored here; in practice they add to the levered fund's losses.

Margin calls and forced selling

As positions lose value, the fund's capital cushion shrinks. If it falls below the level the prime broker requires, the prime broker issues a margin call: the fund must post more cash or collateral, or reduce its positions. Prime brokers can also raise their margin requirements in volatile markets, which has the same effect.

The danger is timing. Margin calls tend to arrive when prices are already falling, so a fund may have to sell at poor prices. If many funds hold similar positions and all sell at once, their selling can push prices down further and trigger more margin calls. This is how leverage can turn a bad period into a severe loss.

What the prime broker provides

A prime broker is a bank or broker-dealer that bundles the services a hedge fund needs to trade:

Counterparty risk

Relying on a prime broker creates counterparty risk: the risk that the prime broker fails, or suddenly withdraws financing, when the fund needs it. Assets pledged as collateral may be reused by the prime broker (known as rehypothecation), subject to limits in the agreement, and a fund could face delays or losses in recovering them if the prime broker failed.

For this reason, larger funds commonly use more than one prime broker. Spreading assets and financing across several firms limits the damage if any one of them fails, gives the fund other sources of borrow if one recalls shares, and lets it compare terms. The cost is more complexity: operations teams must reconcile positions and cash across every prime broker every day.

Key terms

• Short sale: Selling borrowed shares in the hope of buying them back later at a lower price.
• Covering: Buying back shares to close a short position.
• Borrow fee: The fee paid to borrow shares for a short sale; higher for hard-to-borrow stocks.
• Recall: A lender's demand to have its loaned shares returned.
• Short squeeze: A rapid price rise driven by short sellers buying back to limit losses.
• Leverage: Holding positions worth more than the fund's own capital, through borrowing or derivatives.
• Margin call: A demand from the prime broker for more collateral when the fund's cushion falls too low.
• Prime broker: A firm that provides a hedge fund with financing, securities lending, custody, clearing and reporting.
• Counterparty risk: The risk that a firm the fund depends on fails to meet its obligations.

Key takeaways

• A short sale means borrowing shares, selling them, then buying them back and returning them; the fund profits if the price falls.
• Short positions carry borrow fees, recall risk and theoretically unlimited losses, and can be caught in short squeezes.
• Leverage from margin or derivatives magnifies returns: illustratively, a 10% fall in positions is a 20% loss of capital at 2x leverage.
• Margin calls can force a fund to sell at poor prices just when markets are falling.
• The prime broker provides financing, securities lending, custody, clearing and reporting, and larger funds commonly use several to manage counterparty risk.