Institutional investors such as open- and closed-end funds, insurance companies, pension plans, and college endowments usually participate in securities lending. This allows them to lend out portions of their portfolios to generate income. These funds usually lend securities to brokers, who then relend the securities to hedge funds or other investors looking to implement strategies such as short selling. Some investors and fund management companies lend shares to take advantage of the interest paid by the borrower. They may lend out stocks owned in an exchange-traded fund (ETF) and use the proceeds to reduce annual expenses for investors. The prospectus for the fund will spell out whether the ETF is allowed to lend shares and if the proceeds are used to reduce expenses.
How Securities Lending Works
Brokers and dealers usually handle most of the securities lending process. If you as an individual investor wanted to start lending out your securities, you’d likely need to complete a form, and your brokerage would make them available to borrowers. The brokerage would likely take a cut of the interest earned, too. For example, TD Ameritrade states that it takes half of the earned interest. As the lender, you transfer all voting rights and even the title for the shares to the borrower. But you can still sell your position at any time. If you do, the loan agreement will be terminated. If you wanted to short a stock, you’d need to borrow securities to make it happen. You’d need a margin account and then would put in the short order to your brokerage. It would take care of borrowing the shares and selling them for you. You will likely be required to hold a certain amount of equity or collateral for the borrowed shares, too. If the stock price goes up too much, your brokerage may force you to cover the short and buy back shares or deposit more cash as equity (this is known as a margin call). The interest rate you pay to borrow the shares is determined when the shares are borrowed. For stocks, it’s sometimes known as the stock loan fee. The rate is determined by borrowing demand, short selling, and market conditions. Stocks with high short interest will cost more to borrow. Rates can reach double digits for heavily shorted stocks.
Pros and Cons of Securities Lending
What Securities Lending Means for Individual Investors
If you have a portfolio full of long-term positions, it may make sense to allow your broker to lend your securities. The main risk in doing so is that the borrower will default, and the counterparty (the broker) will not have the necessary collateral to make you whole. While that is certainly a risk, it is unlikely. A good interest rate can make up for that risk. On the borrower side, shorting stocks or bonds is a great way to hedge long positions or bet against stocks or industries. For example, if you had a long position that skyrocketed recently, you may choose to short a poorly managed competitor just in case something were to take out the whole industry. You may need to qualify and meet certain requirements before lending out your shares. For example, InteractiveBrokers Stock Yield Enhancement Program is only available to clients who have been approved for a margin account, or those investors who have a cash account with $50,000 or more in equity.
