Not many investors are familiar with securities lending. It might be one of the best kept secrets to adding a little extra to your investing returns without much effort.
Most investors are familiar with the concept of short selling. But do you know how short selling really works? Specifically, do you know how a short seller gets the shares to sell short?
If you’re not familiar with short selling, it’s an investing strategy used when an investor believes a stock will decline in value. To employ the strategy, the investor borrows shares of stock to sell short (selling a stock they do not own). Then the investor waits for the stock to decline in value to buy it back at a lower price and return the shares. If the stock price declines the investor will make money, however if the stock price rises the investor will lose money and may even get margin called.
But from where does the short seller investor get the shares to sell short? That’s what we call securities lending, or sometimes called securities lending fully paid program at some brokerages.
Securities lending overview
Securities lending involves lending stocks, derivatives, funds, or other securities to another investor (the borrower). The borrower puts up collateral for the securities (e.g., cash or other securities). As discussed in the example above, the borrower is borrowing the securities to sell them as part of a short strategy.
Securities lending is not an individual investor to investor transaction though. It is handled by stock brokers who match lenders and borrowers.
In exchange for lending their shares, borrowers compensate the securities lending (owner of the shares) with a fee. This fee can vary depending on the demand to borrow the security. Stocks that are in high demand for shorting will generate higher fees / lending returns.
Securities lending risks
There are some risks to generating income with securities lending. The stocks that are in high demand for short selling are generally more volatile. Holding higher volatility stocks is generally higher risk than holding lower volatility stocks. However, if an investor already holds the stock then there’s not much additional risk from securities lending.
According to securities regulations, short sellers should put up 100% collateral. However there is some minor risk in conducting securities lending. If the stock that was short sold increases drastically in value and the short seller defaults, the collateral may not be enough to cover the stock that was borrowed.
Additionally, the collateral is usually invested in fairly liquid cash-like securities to generate some interest. These investments are generally safe but there have been cases where they have gone bankrupt, losing the collateral.
Overall, if simply lending existing investments in your portfolio, these risks are quite low and securities lending is generally low risk.
Depending on your tax situation and the type of account where the securities are held, there could be tax implications for securities lending. This is because all rights of the stock are transferred to the short seller (and subsequently to the investor the securities are sold to), including the dividend payments. The securities lender is still entitled to the dividend payments, but they may be paid as payments in lieu of a dividend, which can be treated differently than dividends for tax purposes. You should check with your tax accountant for details of how short lending may affect your taxes.
How to start securities lending
If you are interested in securities lending to generate additional income, check with your brokerage to see if they offer securities lending. Ask about or look for information on “Fully paid securities lending” programs as they are usually called. My broker, Charles Schwab, offers securities lending as do many brokerages, so check with yours.
In general, I would not recommend buying specific stocks for the sole purpose of securities lending. However, there is not much additional risk in lending securities already in your portfolio and gaining a little extra return in exchange.