The Interaction between Security Lending Market and Security Trading Market

We develop a simple model to address the interaction between security lending market and security trading market. Whether a security is hard to borrow or not results in two different scenarios of the interaction process. When a security is easy to borrow, short-selling leads to a lower spot price. When a security is hard to borrow, any CHANGE in shorting supply/demand should be largely absorbed by the lending market, and thus have minimal impact on the spot price. We identify three types of market segmentation that contribute to the observed small aggregate short interest and positive lending fee. A positive lending fee implies that the negative opinion of short sellers is offset by the opposite view of security lenders, leaving the equilibrium security price that reflects only the perception of those who neither lend nor short. We further perform static analyses of the change in the scope of the short-selling prohibition, the population mass of potential lenders, the degree of heterogeneity in beliefs, institutional ownership, and margin requirement. The analytical results derived from this model are potentially useful for resolving the debate on the impact of short-selling on security price.