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Few quick questions on how locates work.

  • How do brokerages charge for locates? They charge based on volume? How long you need the locate (I assume an one day is max)?

  • Do the brokerages actually hold the underlier 1:1 with the
    potential short? AKA: If I want the ability to short IBM 1 million
    shares, does the brokerage actually hold 1 million in order to cover? Or do they just hold a certain ratio of the total?

  • How do brokerages hedge themselves against underlier price movement? Do they buy options? I assume that would factor in to the cost of
    the locate.

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1 Answer 1

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I'm not an expert on this topic by any means, but my impression is:

  1. Generally brokers will not charge for locates unless you start asking for a lot more than you end up using. Locates are good for one day only. I would imagine the brokers themselves are charged some small fee for the locate, but for the customer this fee is just part of the commission for executing the trade. If you frequently locate but do not execute, then they are not earning commissions and will either drop you as a customer or start charging for locates.
  2. Brokerages do not hold anything when you request a locate. They merely contract with someone who holds the shares to exclusively put aside the shares for potential short selling with that brokerage. It is often arranged through an inter-dealer broker such as SSgA. The holders are often long-term holders with no plans to sell the shares any time soon.
  3. There is no need for a brokerage to hedge itself, particularly if the broker is acting as a pure agency broker. For orders executed as principal, the story may differ significantly from one broker to another. Even if the brokerage is holding the shares, it is typically holding them on behalf of some other client, which obviously wants the risk associated with that stock. The brokerage is then making a calculated bet that the majority of their clients will not all want to sell their shares on the same day.
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For #1 - I am not sure why the amount you use effects the price, can you explain more? For #2 - Contracting with someone to "put aside" the shares is asking them to take a risk, as it makes what they hold not movable, correct? I'd imagine they are compensated for this risk somehow. #3 - This makes sense if someone else is actually holding the shares, but if the brokerage itself holds them then it stands to reason they are exposing itself to risk in the change of the underlier. –  windfinder May 3 '12 at 15:00

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