Securities Lending Definition: How it Works (2024)

Securities lending is the practice of lending shares of stock, commodities,derivative contracts, or other securities to other investors or firms. It requires the borrower to put up collateral, such as cash, other securities, or aletter of credit.

When a security is loaned, the title and ownership are also transferred to the borrower. Abrokerage charges a client a loan fee, or borrow fee,for borrowing shares, along with any interest due related to the loan. The loan fee and interest are charged according to aSecurities LendingAgreement that must be completed before a client borrows the stock. Holders of securities that are loaned receive a rebate from their brokerage.

Securities lending provides liquidity to markets, can generate additional interest income for long-term holders of securities, and allows for short-selling.

Understanding Securities Lending

Securities lending is generally facilitated between brokers or dealers and not directly by individual investors. To finalize the transaction, a securities lending agreement or loan agreement must be completed. This sets forth the terms of the loan including duration, interest rates, lender’s fees, and the nature of the collateral.

According to current regulations, borrowers should provide at least 100 percent of the security's value as collateral. Collateral for securities also depends on its volatility. The minimum initial collateral on securities loans is at least 102 percent of the market value of the lent securities plus, for debt securities, any accrued interest. In addition, the fees and interest charged on a securities loan will often depend on how difficult it is to locate those securities desired for borrow. The more scarce the supply of available securities, the higher the cost.

Typical securities lending requires clearing brokers, who facilitate the transaction between the borrowing and lending parties. The borrower pays a fee to the lender for the shares and this fee is split between the lending party and the clearing agent.

Pros and Cons of Securities Lending

Pros

• Enables short selling. Securities lending is important to short selling, in which an investor borrows securities to immediately sell them. The borrower hopes to profit by selling the security and buying it back later at a lower price. Since ownership has been transferred temporarily to the borrower, the borrower is liable to pay any dividends out to the lender.
• Helps investors hedge their portfolios. Short selling and securities lending in general helps investors hedge their portfolios, limiting potential losses. For example, if you lend a security to a borrower for a fee, you'll retain that fee even if the share's value drops.
• Allows investors to earn profit from their securities in more ways. With many types of securities, investors won't realize a profit until they sell. Lending a security, for a fee, lets the investor earn a return from that security without selling it.

Cons

• Stockholders lose voting rights on loaned stock. If you own stock, you can vote on important company decisions, such as determining the board of directors. If you loan out a stock, you lose your voting rights, transferring them to the borrower for as long as they hold the shares.
• Determining tax liability can be complicated. When lending shares, it can be complicated to determine who owes tax and what types of tax are owed on things such as dividends, proceeds from the sale of the securities, and fees charged for the loan.
• Borrowers may default and fail to return the owed security. If you lend a security to someone, they may not be able to return it in the future. That would leave you forced to pursue legal action to recover your lost securities or accept the loss.
  

Understanding Short Selling

A short sale involves the sale and buyback of borrowed securities. The goal is to sell the securities at a higher price and then buy them back at a lower price. These transactions occur when the securities borrower believes the price of the securities is about to fall, allowing him to generate a profit based on the difference in the selling and buying prices. Regardless of the amount of profit, if any, the borrower earns from the short sale, the agreed-upon fees to the lending brokerage are due once the agreement period has ended.

Rights and Dividends

When a security is transferred as part of the lending agreement, all rights are transferred to the borrower. This includes voting rights, the right to dividends, and the rights to any other distributions. Often, the borrower sends payments equal to the dividends and other returns back to the lender.

Example of Securities Lending

Suppose an investor believes that the price of a stock will fall from its current price of $100 to $75 in the near future. The stock is not very volatile and generally trades in defined ranges. To profit from this thesis, the investor borrows 50 shares from a securities firm and sells them for $5,000 (50 shares x $100 current price).

Assuming the share price drops to $75, the investor will purchase 50 shares for $3,750 (50 shares x $75 price) and return them to the securities firm. In this case, the profit on this short-sale transaction is $1,250 ($5,000 - $3,750). However, short sales do not always work out as planned. If the investor has miscalculated and the company's shares increase in price rather than decrease, the investor will have to purchase the stock back at a higher price than the price at which they sold it and incur a loss on this transaction.

Securities Lending by the Federal Reserve

The United States Federal Reserve is involved in securities lending, with some Federal Reserve banks lending both American government and governmental agency bonds to certain bond dealers.

For example, the New York Fed holds auctions each business day during which it allocates securities loans to the best available bidder. The more that a firm is willing to pay as a loan fee, the better that firm's chances of winning the bid and securing the loan. These loans assist the Federal Reserve Open Market Committee in implementing monetary policy by smoothing out the clearing of debt securities.

Securities Lending by the European Central Bank

Like the Federal Reserve, the European Central Bank also participates in securities lending. Since 2015, Eurosystem central banks have offered loans for securities purchased under the public sector purchase program, which includes bonds issued by national governments, as well as recognized agencies, international organizations, local and regional governments, and multilateral development banks in the euro area.

The ECB offers securities loans to help keep European markets running smoothly. Under its Expanded Asset Purchase Program, the ECB purchased many securities, reducing the number available on the open market. Securities lending helps increase market lquidity, leading to a more efficient market.

Recent Scandals Involving Securities Lending

Recently, securities lending has led to scandals with some brokers involved in the practice. In December 2023, FINRA fined four companies, M1 Finance, Open to the Public Investing, SoFi, and SogoTrade $2.6 million.

These companies enrolled customers in a securities lending program, allowing the companies to borrow their customers securities and lend them out to third parties. FINRA alleged that these companies did not establish proper supervisory systems for these securities lending programs or have any method for determining where it was appropriate for any specific customer to enroll in the program. FINRA also alleged that the companies failed to offer proper compensation for borrowed securities.

The Bottom Line

Securities lending involves investors lending securities such as stocks or bonds to other investors. This can add liquidity to the market and offer security owners additional ways to earn a return from the securities they own. If you're considering lending out your securities, consider the risks and check with your brokerage to see if it offers securities lending services.