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In recent years, securities lending — making shares available for borrowing by short sellers who “sell first and buy later” — has been an object of increasing regulatory attention. Securities lending is linked to the growth of passive investing because large, buy-and-hold passive investors are among the largest lenders of portfolio securities. But relatively little is understood about the relationship between securities lending and passive investing. In this Article, I show how securities lending allows passive investors to generate revenue from a decline in the value of their investment portfolios in addition to borrowing fees determined by demand from the market. I find that when an active mutual fund exits a portfolio firm, passive index funds belonging to the same fund family raise the cost of borrowing the firm’s shares for short selling. To identify these supply-side shifts, I exploit changes in the identity of active managers which are likely to be uncorrelated with information that would otherwise drive within-portfolio variation in share lending costs. I find that the exercise of market power is pronounced in value lending programs targeting hard-to-borrow securities. Share lenders with market power capture most of the surplus arising from price declines.


Banking and Finance Law | Law | Securities Law