|
THE GLOBAL STOCK market spans about $101 trillion in financial securities. And at any given moment, about $1.7 trillion is out on loan.
Hedge funds, mutual funds, and other traders don’t just buy and sell stock. They borrow it. Sometimes, they’re looking to short sell: If they borrow shares, sell them, and the price goes down, they reap a profit. Other times, they borrow as a way of hedging their stock positions or settling other deals. In the US alone, according to research from DataLend, about $954 billion in securities is typically on loan to some fund or another.
Many players benefit from this little-discussed market. Sure, the borrowers can make some extra money. But the same goes for those who lend the securities out, including retirement funds and other large stock holders. They charge a fee for that loaned stock. And, yes, middlemen take a cut too, including prime brokers such as Goldman Sachs and Morgan Stanley and dedicated lending houses, or “agent lenders,” like BNY Melon and State Street. The agent lenders alone make about $19.2 million a day helping organizations lend out their stock, and the prime brokers likely make even more.
It’s an enormously lucrative market. And it’s a market controlled by a relatively small group of players, most notably the prime brokers. “Securities lending has historically been a closed network,” says Josh Galper, who runs a financial consulting firm, Finadium, that closely tracks stock loans. “In order to lend or borrow securities, you need to be one of the players in this market.”
Patrick Byrne, the iconoclastic CEO of e-commerce site Overstock.com and an unwavering voice for reform on Wall Street, wants to bust this market open. Using technology based on the blockchain—the technology that underpins the bitcoin digital currency—he wants to move the stock-loan market onto the Internet and put it in the hands of, well, everyone. He wants to break the hold of the agent lenders and prime brokers, arguing that, as it stands, they make untold amounts of money from the loan market without giving stock holders their proper share. “We’re taking a market that’s in the dark,” Byrne says, “and we’re putting it on an exchange.”
The Dark Arts
On Tuesday evening, at a cocktail party held inside the Nasdaq stock exchange, Byrne unveiled his bitcoin-inspired stock-loan system under the aegis of an Overstock subsidiary called TØ.com. TØ.com has also used the blockchain to create an online system that can replace the primary stock markets, such as the New York Stock Exchange and the Nasdaq. On Tuesday, Byrne unveiled this system too, saying it was on the verge of receiving approval from the SEC. But the world knew that was coming. The stock loan system was an unexpected reveal. The irrepressible Byrne wants to reform the financial markets in more ways than one.
In both cases, Byrne and TØ aim to remove the dark arts out of the financial markets, to put them online in a way that all transactions can be carefully verified, to ensure we always know who holds a given share, to limit the role of Wall Street middle men. The blockchain is essentially a massive online ledger, driven by a vast network of independent machines. With bitcoin, this ledger puts the money system in the hands of the people, limiting the role of big government and big banks. Now, Byrne wants to do the same for the financial markets.
Some question whether Byrne is in a position to change these markets—no matter how powerful his technology. But separate from his efforts, Wall Street is waking up the notion that the blockchain can streamline our financial markets. This spring, Nasdaq itself announced that it will use the blockchain to drive a private stock market, and two other outfits, Digital Asset Holdings and Symbiont, are developing their own blockchain-based systems for the securities trading.
‘Pre-Borrow Assurance Tokens’
But Byrne’s stock loan system is unique. Based on blockchain-like technology from a startup called Peer Nova, it will allow pension funds and other stock holders to lend shares directly to hedge funds and other traders, essentially removing middlemen such as agent lenders and prime brokers from the process.
The setup is relatively simple. Stock holders will attach bitcoin-like digital tokens to each share of stock. Hedge funds and other traders will bid for the right to borrow shares. And then, thanks to the tokens, known as “Pre-Borrow Assurance Tokens,” or PATs, stock holders can closely track each transaction involving their loaned stock.
The system is an outgrowth of Byrne’s well-documented experiences on Wall Street. A decade ago, Overstock was the victim of what’s called naked short selling, where traders exploit a loophole in the system to short sell stock without actually borrowing it—a practice that can drive down a stock’s value. After the financial crash of 2008, the SEC moved to close this loophole. But with his blockchain-based systems, Byrne wants to ensure this kind of thing is eradicated entirely—in addition to streamlining the stock loan system as a whole.
Risk Versus Reward
Galper calls the system interesting, though he questions whether the existing players will end up using it. “As with any closed system, the greatest beneficiaries of that system are the biggest participants,” he says. “Would the largest borrowers and lenders be keen to move to a new system and to provide more equal access to borrowers and lenders? I don’t believe so.”
What’s more, he explains, lenders are happy with the existing system because the agent lenders (typically large banks) provide what’s called “counter-party default indemnification.” This amounts to insurance for the shares sent out on loan. With TØ’s system, lenders must have a similar assurance that when they loan their stock, they’ll get it back.
“This is a question of risk versus reward,” Galper says. If you’re willing to take additional risk by lending directly to a hedge fund, then you’re going to get greater reward. On the other hand, it is your responsibility to monitor that hedge fund, to insure that it is a good credit risk, that it pays on time, and that you get your stock back at the end of the transaction.”
According to Byrne, TØ.com does have ways of limiting counterparty risk. Initially, he says, lenders can use these system while keeping their shares with a large prime broker, such as Goldman Sachs, who can continue to provide default indemnification as always. So, the prime brokers will remain part of the process, but they may not benefit nearly as much as they did in the past.
The New Middleman
On the other side of the equation, Galper believes, smaller hedge funds may be keen to use TØ’s system. After all, it will allow them to borrow shares at a cheaper rate. “The smaller a hedge fund you are, the more incentive you have to look for alternatives. If you have an opportunity to eliminate your middleman, then you can lower your price for borrowing.”
Yes, Byrne and TØ.com are now Wall Street middlemen. But Byrne insists that they will charge lower rates than the incumbents, because their technology takes so much fat out of the market. And the larger point, he says, is this new system can give the market the transparency is has never had.
Even if the system fails to replace the existing players, he says, it can push Wall Street in the same direction. On Tuesday evening, his primary message was that he’s willing to share this technology with others. “We’ve shown the world what we have,” he says, “and now I’m willing to listen to anyone who wants to talk.”
|
Show Posts
need ICO! start
