Are Security Lending Fees Priced? Theory and Evidence from the U.S. Treasury Market

I study the extent to which security lending fees affect prices in the context of search frictions in the repo market, and make three main theoretical contributions to the literature on shortselling: 1) I incorporate heterogeneity in investors’ access to the repo market, and show that securities become slowly “locked up” from the repo market as short interest builds up; 2) I provide testable predictions that distinguish whether short selling is due to hedging or arbitrage activity; 3) I show that when short-selling is driven by the hedging, the proportion of observed future lending fees that is priced is less than one and decreases as short interest builds up. I provide new stylized facts and test the model’s implications using repo-rate data from regular US Treasury auctions. I find evidence that short-selling in on-the-run US treasuries is motivated by hedging rather than arbitrage activity. The hedging-based model matches a number of empirical patterns in prices and repo fees over regular auction cycles in US Treasury notes.