Securities lending is a method for improving the yield on your long-term equities holdings by lending them out to other investors, primarily short sellers. Investors who lend their securities are rewarded with a small premium, shared with their bank or broker, that the borrower pays to access the shares. The lending investor takes on a small risk that, should the borrower go bankrupt, they may not be able to recover the full value of their shares. The payment additional covers the inconvenience of not being able to sell those shares during the period they are loaned out for. Not suitable for every investor, securities lending is an interesting opportunity for those who want extra yield and don’t mind a little additional risk to achieve it.
Who lends securities?
You do – that is, investors holding stocks in a trading account. Of course you cannot privately loan out securities, so in practice it is your bank or broker who takes care of the mechanics of the lending process. For this, the fees are split between you and your broker. Previously only very large investors loaned out securities, such as investment management funds and banks, because of the sheer quantity required. A more recent innovation is to chunk together multiple different holdings from smaller investors, in order that a large overall loan may be made by dozens or even hundreds of retail investors. It is this feature which had brought securities lending into the world of retail investment.
Saxo bank group is one of several major financial institutions that offer securities lending to their clients. You can simply check online or by calling a financial advisor to find out whether your bank or broker is one of them, and then be sure to ask for more information to confirm how they split fees / the exact terms and conditions of the agreement. Because these agreements are non-standardised, they vary considerably and you should not assume the content of yours based on how they normally function.
Who borrows securities?
The most important reason for securities lending is short selling. Short sellers try and express a negative view on the price of a stock by borrowing it at the current market price, waiting for the price to decline, then replacing the borrowed stock with purchases of the same stock at a later, lower price. They then profit by the downwards change in price, minus the cost of borrowing (which goes to the owner of the shares / their broker).
Long / short equity funds are a type of hedge fund that uses a percentage of its portfolio to fund short positions in vulnerable shocks. The idea is that these will both act as a hedge in the event of a general market downturn, and also provide an opportunity to speculate on price declines in struggling companies.
It’s a neat system, but in practice short selling is a high risk activity. Because equity prices have no upper theoretical limit, the potential losses from this sort of trade are also unlimited. When borrowing stock, equity investors need to return them at a particular date – or else pay increasing premiums to keep the trade open – which can swiftly become prohibitively expensive. If a stock increases in price by 200%, a short seller will face a loss of three times the original sum paid. Once you factor in the leverage often used by long / short equity funds, this becomes a catastrophe. Single bad trades have destroyed major funds in the past, which creates a complicated situation for their equity lenders.
How share lending is profitable
Share lenders make money because of two reasons: the risk of bankruptcy on the part of the borrower (credit risk), and the limitations of owning lent-out stock (inability to sell at will). Investors are rewarded for these two risks with a premium, which while fairly low is still enough to add a regular income to your portfolio.
Share lending is only suitable for long term holdings, as you will be unable to sell the shares when the borrower owns them. If you plan to liquidate some of your portfolio in the coming months, it is unwise to lend them out before. Instead, investors should make available for lending only those shares which they are committed to holding for many years.
One of the problems is that short sellers prefer to attack – sorry, target – companies that are in financial distress or with long-term problems. When long-equity investors buy these shares, they normally do so as part of a shorter term strategy aimed at seeing a small gain in the price of a volatile equity. These are the worst sort of holdings to lock away by lending out, so there is a clear mismatch between the priorities of the short seller and the long equity holder.
It is true that there are other reasons why investors might want to borrow equities – sometimes regulatory or capital requirements insist they hold a certain number of shares – but short selling remains the most important driver of securities lending profits. It is worth remembering that a long equity portfolio that is extremely attractive to securities borrowers, may well be a bad portfolio.
Conclusion
We have looked at some of the drivers of the securities lending market, and highlighted how you can check with your bank or broker to see if the service is available for you. It is important to understand how short sellers make money to reach a decision on whether it is right for you, and variation in individual contracts means that it is essential to read yours before entering such a contract. Significant differences in profit sharing and the terms of the lockup can be found from provider to provider. If you find yourself struggling with the terms of a contract, run it past a financial (or perhaps legal) professional. Once you are happy with both the terms of the deal and its limitations, securities lending can be a good way to maximise the yield on long-term equities holdings.
