Failure is an Option:

A regulatory advantage of options market-makers significantly weakens the link between short sales and equity loans. Their advantage is an option to fail to deliver shares, created by their ability to sell short without first identifying a lender. Two years of transactions by a major market-maker shows failed deliveries in half the hard-to-borrow situations, and not a single negative-rebate loan. Buy-ins, or forced deliveries, are rare, and their execution near the market. Despite this low cost of short exposure, options on hard-toborrow stocks trade far from parity, implying significant economic profits for the market makers. This equilibrium is a puzzle, for which we offer potential resolutions. * Evans, Geczy and Musto are from The Wharton School at the University of Pennsylvania. Reed is from the Kenan-Flagler Business School at the University of North Carolina. We gratefully acknowledge important input from Michael Brandt, George Constantinides, Patrick Dennis, Darrell Duffie, Bin Gao, Jonathan Karpoff, Richard Rendleman and seminar participants at Wharton and the 2001 Western Finance Association Meetings. We thank Wes Gray for excellent research assistance. The Frank Russell company generously provided constitution lists for their Russell 3000 index.