The Locate Requirement in Practice: Navigating Hard-to-Borrow Lists

Rule 203(b) of Regulation SHO requires a broker-dealer to have reasonable grounds to believe that a security can be borrowed and delivered on the settlement date before effecting a short sale. This is known as the 'locate' requirement. For most liquid securities, this is a seamless, automated process. However, for securities that are in high demand for shorting, the locate process can become a significant hurdle for traders.

When a security becomes 'hard-to-borrow' (HTB), brokers will place it on a restricted list. To short a security on the HTB list, a trader must have a 'locate' – a specific confirmation from the broker that they have secured the shares to borrow. This process is often manual and can involve significant costs.

Understanding Hard-to-Borrow Lists

Hard-to-borrow lists are dynamic and can change on a daily, or even intra-day, basis. The factors that can cause a security to become hard-to-borrow include:

• High Short Interest: When a large percentage of a company's float is sold short, the supply of shares available for borrowing can become constrained.
• Corporate Actions: Events such as mergers, acquisitions, and spin-offs can create uncertainty and increase the demand for shorting.
• Low Float: Securities with a small number of shares available for public trading are more susceptible to becoming hard-to-borrow.

The Costs of Locating Shares

When a security is hard-to-borrow, brokers will charge a fee for locating shares. This fee, known as the 'locate fee' or 'borrow fee', is typically expressed as an annualized percentage of the value of the shares being borrowed. The fee can range from a few basis points for moderately hard-to-borrow securities to over 100% for securities that are in extremely high demand.

For traders, the borrow fee is a direct cost that can significantly impact the profitability of a short sale. It is essential to factor in the borrow fee when calculating the potential risk/reward of a trade.

Strategies for Navigating the Locate Requirement

For traders who frequently short hard-to-borrow securities, there are a number of strategies that can be used to navigate the locate requirement:

• Multiple Broker Relationships: Different brokers have different access to the securities lending market. By having relationships with multiple brokers, traders can increase their chances of finding a locate for a hard-to-borrow security.
• Pre-borrowing: For securities that are expected to become hard-to-borrow, traders can pre-borrow the shares before they are needed. This can be a more expensive option, but it can guarantee that the shares will be available when they are needed.
• Options Strategies: In some cases, it may be more cost-effective to use options to create a synthetic short position rather than shorting the stock directly. For example, a trader could buy a put option or sell a call option to profit from a decline in the price of the security.