On Brokerages Facilitating Short Selling

     Naked shorts should not be allowed. Additionally, a rental market should be created where stock holders can rent out their shares (giving up their ability to sell those shares). Since these shares can be rented, they would be an ideal market for bears to rent shares of companies they wish to short. To make this market work, brokers should not be allowed to retain ownership of stock held by their clients, allowing the original investors to decide whether or not they wish to rent their shares for short sale.

Recent News:
    Yesterday the FED announced that they were going to ban naked short sales. While this is a long overdue move, there is still a lot more that can be done to improve the incentives that drive the self-calibrating nature of the stock market.

Brief Analysis:
    I've reposted a link to Max Keiser's People and Power report on the "death of a dollar", which discusses the dangers of allowing naked positions. Its fairly obvious why naked shorting is a bad idea so I will not go into it in depth, unless someone requests I do so.
    Currently, brokers are allowed to lend stock held by their clients to other clients who can sell the stock as long as they promise to buy the stock back later and return it to the original owner [more details here]. It is my claim that there is an underlying problem with this set up; the current set up violates a fundamental assumptions of the free market that "behavior is economically rational".
    Lets consider what happens if brokers were not allowed to rent their clients' shares, instead, clients had the ability to choose whether or not they would rent their shares out. Lets say our investor, Joe, truly believes a company will go up so he buys the shares and does not plan on selling his shares anytime soon. If there is demand for shorting the companies shares, then Joe can find someone who wants to short the companies shares and rent his shares to them for a fee. Since, Joe is in it for the long haul and believes the stock is headed up, it doesn't hurt him to let others try to profit from short term dips. Of course, Joe is going to want the shares back at some point, so he must work out a time limit with respect to any shares he rents out. When renting his shares out, economically rational behavior would be to look for the person willing to pay the highest rental fee. The rental fee offers Joe a guaranteed income on his shares as compensation for the opportunity cost Joe incurs by not trying to profit off of short term dips. Great. Clearly allowing share holders to rent their shares out for themselves is economically rational.
    To understand why allowing brokerages to rent shares held in a client's margin account leads to economically irrational behavior, one has to look at the incentives that drive a brokerage. Maximizing Profit. Brokerages earn a large sum of money from the transaction fees they charge their clients. These transaction fees are usually either a flat rate, a function of the number of shares involved or sometimes the profit made on a position. As a result, when brokerages try to maximize profit, they will also try to maximize transactions. To maximize transactions, it helps that they can lend their clients share's to another client or brokerage that wants or has a client that wants to short a particular stock. The key factor here is that the supply of shares available for rent is not dependent on demand. With a fixed supply, any changes in demand should directly affect the price. The image here shows how with a fixed supply curve, a decrease in demand should lower the price. Similarly, an increase in demand should increase the price; however, since brokers have the incentive to maximize transactions, they have the incentive to lend and borrow irrespective of the demand for rented shares. This leads to economically irrational behavior since people can easily borrow shares of a company irrespective of what the demand for renting such shares is.
    An efficient market works well, in my opinion, because of all of the feedback systems built into one to make it a self-regulating system; however, when brokers are allowed to lend shares of their clients, the market does not benefit from self-regulation. Hence, allowing brokers to lend the shares held by their clients leads to economically irrational behavior of the market.

Thought Experiment 1:
    What is wrong with proposing that brokerages continue to be able to lend the shares held by their clients and at the same time they charge clients a fee based on the demand for shares they are holding short? Hint: consider what happens when large brokerages try to skip exchanges altogether and fill transactions internally.|

Thought Experiment 2:
    What factor other than stock and rental fee would a the share rental market discussed in this post have to into account. Remember this market would have to be an economically rational market. Hint: take a look at how stock markets differ from options markets.

Related Links:
 - People and Power: "Death of a Dollar"
 - Who Benefits from Share Rentals?
 - Free Market Assumptions
 - Wall Street's Top Firms Increasingly Resorting to Internal Trading