Many investors don’t own securities directly, but rather through funds—which typically hold a variety of securities. Most fund managers take a long-term approach to investing. They want to buy and hold securities, with minimal trading in and out of their portfolios, to hold down costs. 

What else can they do to boost portfolio returns, while waiting for long-term growth in the value of the securities? They can lend the securities to other investors, who promise to return the securities within a designated time limit.

What is securities lending?

Securities lending might be called securities renting, because the lenders are doing just that—renting out securities in their portfolios for short periods, usually less than a year. It is a well-established activity in financial markets, with about $2.5 trillion of securities on loan globally as of the third quarter 2020, according to an oversight panel of the U.S. Treasury Department. The US accounts for more than half of the securities lending market.

Stocks, bonds, commodities, futures and other derivatives can be lent and borrowed. The focus here will be on stock lending.

The main types of securities lenders are mutual funds, exchange-traded funds (ETFs), pension funds, and college endowments. They lend securities from their portfolios to collect fees paid by the borrowers. The fee income enhances a portfolio’s rate of return. Index funds and ETFs are typically sought as favored lenders because of the size of their portfolios and their long-term investment strategy, which allows them to have more stocks out on loan periodically.

The main borrowers are short sellers—investors who want to bet on declining stock prices. Brokers and dealers (market makers) typically arrange securities lending transactions as agents on behalf of lenders and borrowers.

A lender and borrower, along with the agents, must enter a formal agreement called a securities lending agreement. It’s like a lease to rent a property, spelling out each party’s rights and obligations.

The borrower pays a fee for the borrowed stock, typically due each month for the loan’s term—again, like rent on a property. Fees are generally less than 1% of the borrowed shares’ value for large-cap stocks that are easily traded; harder-to-obtain stocks can command higher fees. The lender shares the stock fee with the broker.

The borrower must also pledge collateral, equal to or greater than the value of the borrowed stock. Usually the collateral is cash, but it could also be a letter of credit or U.S. Treasury securities.

The collateral typically is 102% to 105% of the borrowed stock’s value, as a buffer for the lender, in case the collateral value declines during the lending term or if the borrowed stock increases in value. This is monitored daily on a market-to-market basis during the loan’s term.

How does securities lending work?

A securities lending transaction might look like this:

Imagine a company, XYZ Inc., which has about 15 million shares outstanding and a market cap of $1.5 billion, with the shares trading at about $100. The share price has doubled in the past two years.

Among XYZ’s biggest shareholders is a hypothetical exchange-traded fund, ABC Healthcare ETF, with about 140,000 shares.

A securities brokerage contacts the managers of the ETF to ask if it can borrow 1,000 shares of XYZ, on behalf of a client, for six months. The brokerage says the client believes XYZ’s stock price will drop to $80 within that period and wants the shares to sell short.

The ETF agrees to a six-month loan of 1,000 shares, valued then at $100,000, to the brokerage client, who in turn will pay a loan fee of 3% annualized, and will put up $102,000 cash as collateral. The client sells the shares for $100,000. The ETF will invest the collateral in very liquid short-term debt securities such as U.S. Treasury bills during the loan term.

Four months into the loan, XYZ shares have fallen to $90. The brokerage client decides to buy 1,000 shares for $90,000, for a $10,000 gross profit. The loan fee of 3% on $100,000 amounts to $250 monthly, so the ETF gets $1,000 for four months, plus whatever small amount of interest is earned on the collateral. The client returns the shares, and the ETF returns the collateral.‍

Potential benefits of securities lending

Securities lending comes with a range of benefits, some that aid the smooth functioning of financial markets and others for certain investors in specific situations.

General benefits

• Increases liquidity in financial markets.

  This is particularly true for the over-the-counter stock market. Greater liquidity leads to narrower bid-ask price spreads, which is better for all market participants. The lender’s investment of collateral further adds to liquidity in markets.

• Lets investors take a contrarian view of a company’s prospects.

  This is because they’re able to borrow shares and sell them short.

• Allows lenders to hedge long positions.

  For example, a hedge fund may be generally bullish on the pharmaceutical industry and owns shares in several drugmakers, but thinks some others in the industry are weaker, so it sells their shares short.

• It can also be used in arbitrage.

  Here, an investor buys an asset in one market and simultaneously sells the asset in another market, to exploit temporary price discrepancies such as those arising from currency fluctuations. An arbitrage trader in stocks, for example, could buy Company A shares in Europe and simultaneously borrow and sell the US shares of Company A to capture any discrepancy from a change in the dollar/euro exchange rate.
  

Benefits for fund investors

• Lenders such as funds can generate some easy extra income from fees received for lending shares, with minimal risk. They will charge higher fees for thinly traded stocks and for those with many shares sold short than for easily traded shares of bigger companies.
• Securities lending adds some diversification to a fund’s portfolio of buy-and-hold investments, to the degree that the lending moves it beyond passive investing.

Risks of securities lending

Short sellers are the prevalent borrowers in securities lending. They are betting on a declining stock price, so their risk is that the price rises, and they lose money on the trade.

The lender has several risks. They include:

• The collateral’s value falls below the value of borrowed stock.
• The borrower fails to return the stock.
• Giving the stock to the borrower before receiving the collateral.
• Loss of ownership rights during the loan term. Securities lending agreements temporarily transfer ownership of shares to the borrower, so that if a shareholder vote on some matter is scheduled, such as a proxy vote, the lender must be able to close the loan quickly and call back the shares.
  

Funds are required to say in their prospectuses if they can engage in securities lending, and in their semi-annual filings with shareholders and the Securities and Exchange Commission, they must disclose any securities lending.

The bottom line

Securities lending generally can provide a small boost to a fund’s rate of return—an easy pickup of money for the fund as long as the lender, borrower, and their agents have well-established protocols and experience with such agreements, to minimize the risk to the lender. It also increases market liquidity and gives short sellers a way to take a contrarian position in stocks—a curb on enthusiasm when market prices get overheated.