In their paper Inefficiencies in the Securities Lending Market, Rottke and his co-authors show that something is going wrong in the market for borrowing shares. This market is crucial for short selling: you borrow a share, sell it at today’s high price, and buy it back later if the price falls. Short sellers play an important role. They help spot overpriced, low-quality companies and reduce the risk of price bubbles.

The problem is the cost. While most trading costs have gone down over the past 15 years, the fees for borrowing overpriced shares have skyrocketed. In extreme cases, these fees are more than 100% or even 1,000% per year. In the US alone, this inefficiency costs investors about $300 million every day. A big reason is the role of middlemen, such as large banks. They keep around 40% of the borrowing fees. As a result, the actual share owners—like pension funds and mutual funds—receive only about 60 cents of every dollar paid by short sellers.

This creates a new problem. Even when these investors lend out their shares, holding such stocks is no longer worthwhile. Many therefore choose to sell them altogether. Ironically, this makes the shares even harder to borrow, pushing fees up further and making the market work even less efficiently.

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