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Brokerage firms gather information about short sellers’ trading based on their activity in the securities lending markets and leak this information to clients, improving the efficiency of markets, according to new research.

In a new working paper published by the U.S. National Bureau of Economic Research (NBER), a trio of academics — Fernando Chague and Bruno Giovannetti from the Sao Paulo School of Economics and Bernard Herskovic from the UCLA Anderson School of Management — examined short-selling activity in the Brazilian markets, uncovering a mechanism for short sellers’ knowledge to find its way into stock prices.

Their research used granular data on the Brazilian securities lending market and from the centralized stock exchange to identify “trading execution mismatches between short sellers’ selling activity in the centralized exchange and borrowing activity in the over-the-counter securities lending market.” 

They found that brokerage firms learn about short sellers’ bets intermediating securities-lending transactions for those traders, and they leak that information to their other clients. 

“We find evidence that the information leakage is intentional and that brokers benefit from it,” the paper said. 

Specifically, the researchers found that brokers can identify which short sellers are well informed based on their track records, and that when a skilled short seller seeks to borrow a large position in a specific stock, this points to the seller being “fully committed to a sizeable directional bet.”

The researchers then analyzed how the clients of brokers involved in these securities lending agreements trade in the wake of successful short sellers’ securities-borrowing activity to find evidence of information about their trading leaking into the market. 

Specifically, they found that clients of a broker with knowledge of a skilled short seller’s trading intentions immediately become net sellers of that same stock. 

“This means clients move towards a bearish-like behavior compared to non-clients on the same day their broker becomes aware of an informed securities lending event. The difference in trading behavior between clients and non-clients is statistically significant and economically large,” the paper said.

At the same time, they examined the trading behaviour of brokers’ clients in the wake of a short seller with a poor track record signalling their intentions through securities-borrowing activity, and they found no difference in trading behaviour between clients and non-clients. This, the researchers concluded, represents “strong evidence of intentional information leakage” by brokers about the skilled short sellers.

This sort of information leakage pays off for the brokers as it translates into increased client loyalty for them, the research also found.

Looking at the trading behaviour of clients that, the researchers believe, were tipped off by their brokers, they found that, “in the subsequent months after the event, these clients bring more business to the broker by engaging in more security borrowing and lending with that broker.” 

Finally, they also found that this information leakage improves market efficiency as it “leads to a faster drop in stock prices, lower stock return volatility and lower serial correlation.”