Securities Lending

What Is Securities Lending?

Securities lending is the practice of loaning shares of stock, commodities, derivative contracts, or other securities to other investors or firms. Securities lending requires the borrower to put up collateral, whether cash, other securities, or a letter of credit.

When a security is loaned, the title and the ownership are also transferred to the borrower. A loan fee, or borrow fee, is charged by a brokerage to a client for borrowing shares, along with any interest due related to the loan. The loan fee and interest are charged pursuant to a Securities Lending Agreement that must be completed before the stock is borrowed by a client. 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.

Benefits of Securities Lending

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.

In these transactions, the lender is compensated in the form of agreed-upon fees and also has the security returned at the end of the transaction. This allows the lender to enhance its returns through the receipt of these fees. The borrower benefits through the possibility of drawing profits by shorting the securities.

Securities lending is also involved in hedging, arbitrage, and fails-driven borrowing. In all of these scenarios, the benefit to the securities lender is either to earn a small return on securities currently held in its portfolio or to possibly meet cash-funding needs.

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. In order to profit from this thesis, the investor borrows 50 shares of the company 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 then 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 end up increasing in price rather than decreasing, the investor will have to purchase the stock back at a higher price than the price at which they sold it and will incur a loss on this transaction.