The social function of equity deposits

One more post on equity deposits.

My last post described a dirt cheap (and hypothetical) way for long-term investors to get exposure to equities. Briefly, an investor commits a certain amount of money to a one-year term deposit that promises an equity index-linked return. The manager of this equity deposit (ED) invests that money in an appropriate number of shares in the companies that make up the index, then lends these shares out to borrowers for one year at a fixed rate. At the end of the year the stocks on loan are recalled, sold, and the investor's deposit is repaid. The interest earned on stock loans is shared with the depositor, boosting their returns.

It's worth pointing out that ETFs already lend out shares, but unlike an ED they can only do so on an overnight basis. So an ETF can't harvest the extra term premium on long-term loans.

EDs have a broader social purpose than just saving a few bucks. Here's a quick list:

1. Equity deposits would reduce the dead weight loss currently being incurred by long-term investors.

The investing world currently discriminates against long-term investors by requiring them to invest in securities that are tailor-made for short-term traders. Stocks, ETFs, and mutual funds enjoy a permanent trading window--the ability to cash out of the stock market in a millisecond. Long-term investors who have precommitted to the stock market for ten or twenty years simply don't need this feature. Unfortunately, not only do they not have a choice (all securities have these windows), but they must pay the fees involved in the maintenance of said window. This is an an efficient allocation of resources, or what economists call a dead weight loss.

Equity deposits are tailor-made for the long-term investor. By removing the trading window, long-term investors no longer have to pay for a feature that caters to traders, thus lowering investors' costs and improving their returns. The world is made more efficient.

2. Borrowers of stock are missing a market. Equity deposits would fill this gap.

Anyone who wants to borrow dollars from a bank can do so overnight or on a long-term basis. It's not the same when it comes to other financial instruments. Anyone who wants to borrow stock can only do so overnight. An equity deposit provides the missing market.

The reason for this gap is that institutional owners of stock like ETFs and mutual funds face the possibility that they might be besieged at any moment by redemption requests. This means that they can only lend out stock on a short term basis to borrowers, usually overnight. Because owners of equity deposits have committed to a fixed holding period, the manager of an ED is free to lend underlying stock out on a long-term fixed rate basis. Borrowers should be willing to pay an ED manager a premium rate of interest for the certainty its fixed products provide.

Which leads into points 3, 4, and 5...

3. Equity deposits would improve market liquidity and reduce price volatility.

The job of a market maker is to facilitate trading in a security by maintaining tight spreads between the bid and ask price. Market makers need an inventory of securities to do their job, and they will often borrow to ensure that supply. Because most shares are lent out on an overnight basis, this source of liquidity is flighty. Stock can be recalled without warning and lending rates can get ratcheted up suddenly. A manager of an ED can offer market makers a guaranteed supply at a fixed price, thus reducing the uncertainty involved in market making. Hopefully this will help make for a thicker and tighter market.

4. Equity deposits would improve price discovery.

Arbitrageurs need to borrow stock to put on the short leg of their strategies. Because most equity loans can be recalled at any moment and lending rates can change daily, it can be difficult to know ahead of time the return of a certain strategy. Equity deposits provide a stable long-term supply of stock for arbitrageurs at a fixed lending rate, thus helping to ensure that the arbitrage process keeps prices in line.

5. Equity deposits provide a useful risk management tool.

Hedgers may need to borrow stock and sell it to hedge some other position they hold, thus offsetting risk. Long-term fixed interest rate loans may offer the hedger more peace of mind than a series of overnight loans that might be reset at higher interest rates without warning.

In closing, ETFs and index mutual funds have become more than just vehicles for retail investors to get passive market exposure. They have also become intermediaries between overnight lenders and borrowers of stock, even if most retail investors in ETFs do not actually realize that they have become lenders. An equity deposit mimics the passive market exposure provided by an ETF while extending the lending business from an overnight basis to what should be a more profitable long-term basis.

It is generally accepted that stock lending brings stability to the marketplace. But as we know from the financial crisis, overnight markets are run-prone. Long-term stock lending via an ED solves the run problem; it seems like an incremental way to create a more robust system.

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