Securities Lending: Definition and How it Works

Key Takeaways

• Securities lending is the practice of lending shares of stock, derivative contracts, commodities, or other securities to other brokers or firms.

• Securities lending is a well-established practice by institutional investors such as funds, insurance companies, college endowments, and pension plans.

• Funds that participate in securities lending usually lend their securities to brokers or dealers who, in turn, relend the securities to hedge funds and others.

Securities lending is key to a variety of trading activities including hedging, arbitrage, short selling and more. It is a way to draw profits or meet cash-funding needs and allows for short selling. But just what is this practice? Here is securities lending: definition and how it works.

What is Securities Lending?

It is the practice of lending shares of stock, derivative contracts, commodities, or other securities to another party, usually facilitated by a brokerage firm. 

In exchange, the borrower shifts other bonds, shares, or cash to the lender as collateral and pays a borrowing fee, usually monthly, which is split between the lender and the clearing agent. The borrower is required to return the securities upon demand or at the loan period’s completion.

Here is a securities lending example:

Say Jim, a securities market trader, has been tracking the stock price of XYZ Ltd. It is his belief that the price will decrease within the next two months from $150 per share to $100. Thus, Jim goes to a fund’s securities lending agent, Topline Securities, and borrows 70 shares of XYZ Ltd. He then sells them at the current market price and earns $10,500 (70 x $150).

As predicted, the stock price drops to $100 after two months, and Jim buys shares at that price. Therefore, He spends $7,000 (70 x $100) and through the short-selling transaction profits $2,500 (10,500 – $7,000).

The upshot of the above scenario is that the lending agent permitted Jack to benefit from the drop in price to earn a profit.

In another example, an investor believes a stock price will soon drop from its current price of $100 per share to $75. The stock is generally not that volatile and trades in expected ranges. In hopes of profiting, the investor borrows 50 company shares from a securities firm and sells them for $5,000 (50 shares x $100 current price).

Assuming that the share decreases to $75, then investors will subsequently buy 50 shares for $3,750 (50 shares x $75 price) and give them back to the securities firm. Although it does not always work out as planned, the investor here did profit $1,250 ($5,000 – $3,750) on the short sale. 

Note that not every fund is allowed to lend securities. The investor’s fund prospectus or the Key Investor Information Document can reveal that information.

Is Securities Lending a Common Practice?

Securities lending is a well-established practice by institutional investors such as funds, insurance companies, college endowments, and pension plans. Funds that participate usually lend their securities to brokers or dealers who, subsequently, relend the securities to hedge funds and others.

Also, securities lending commonly allows short sellers to borrow needed securities and execute their short sales, in which an investor borrows securities to sell them right away. The hope is to profit by selling the security then buying it back at a lower price.

The practice also facilitates investors or institutions in arbitrage situations, wherein exists the simultaneous purchase and sale of the same or similar security in varying markets to profit from minute asset price differences.

Benefits of Securities Lending

There are some advantages to securities lending for buyers and lenders, including:

• Borrower’s rights. Because the borrower possesses the securities, albeit temporarily, they have stock voting rights, can earn dividends, and join in any other organizational distributions.
• Help with strategies. Borrowed securities can help with strategies such as hedging – taking advantage of price differences in varying markets to turn a profit.  
• Ownership remains with the lender. This is true even after securities are lent.  Thus, the fee and interest the lender can charge hinges on the difficulty of borrowing such securities.
• Extra income from borrower fees and interest. Securities lending rates are contractually established and help fund investors pay management fees.
• Facilitates short selling. Here, investors first sell securities with the aim of purchasing them later at a lower price. So, after selling, the investor or buyer borrows the assets at a lower price. Hedging and arbitrage also benefit the lender.

Risks of Securities Lending

There are risks involved in every investment, and it is true for securities lending, for buyers and lenders:

• Reinvestment losses. The lender could sustain losses while reinvesting the collateral. This means that even if stock lending produces income, reinvestment losses dilute it.
• Security value rises. If the security value increases following a short selling, the borrower will lose money because they must borrow the securities at a higher price than they sell.
• Risk of insolvency. There is always the risk of loss if the borrower defaults before securities are returned.
• Drop in collateral value. There is also the risk that the collateral’s value falls below the cost of replacing the lent securities.
• Delay in collateral. Such a delay can be risky since, during delivery, the lender has no security. 

What is the Securities Loan Agreement?

To finalize the transaction, there must be a securities lending agreement or contract that clearly spells out the interest rates involved, the broker’s loan fee, the loan’s duration, and the collateral type.

What is the Importance of Collaterals in Securities Lending?

There are various types of acceptable non-cash collateral including specific equity index baskets, sovereign debt, global equities, specific supranational debt, or investment-grade corporate bonds. The overall market value of borrowed securities should be less than that of the collateral.

In addition to U.S. dollars, cash collateral can be Canadian dollars, Euro, Yen, Australian dollars, and British pounds.

Note that the collateral should equal or exceed the security’s total market value.

Generating Additional Income Through Securities Lending

Securities lending is a creative way to generate income through the stock market. However, putting capital in alternative investments – assets other than stocks and bonds – could be even more creative. Such investments are increasingly popular for their low correlation to public markets, rendering them less volatile and vulnerable to inflation.

As it is, the platform Yieldstreet has more than $3.6 billion invested on it to date with net annualized returns of 9.8%. It offers a broad selection of highly vetted alternative asset classes, from art and real estate to private credit and transportation.

Interspersing alternatives with stocks and bonds also serve another purpose: diversification. Diversifying one’s investment portfolio is essential to long-term successful investing because it spreads out risk: if one asset class is underperforming, another one can step up.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

While not without risk, securities lending can be used to increase investor returns incrementally. It is an innovative way to produce revenue via the stock market. Remember that there are other means of doing so that do not directly involve the market as well.