Securities Lending — The Back End of Short Selling
Where does the short seller borrow the stock they sell? From another investor who owns it — perhaps you. That back end is securities lending.
What Is Securities Lending
Securities lending is a transaction in which you lend stock you hold to another investor (mainly institutions) for a set period and receive a lending fee.
The borrower is mostly a short seller. To short, you must first borrow the stock, so without securities lending short selling itself cannot take place. That is why securities lending is called 'the back end (infrastructure) of short selling.'
The borrower puts up cash or other securities as collateral, and the lender collects a fee in return.
What's Good for the Lender — and What's Risky
From the lender's side, the appeal is earning 'extra income without selling the stock you hold.' The lending fee becomes income.
Fees vary widely by stock. Stocks with large market caps and abundant supply carry a low fee of around 0.3% per year, while hard-to-borrow stocks carry a much higher fee.
But there are risks too: (1) counterparty risk that the borrower goes bankrupt and you can't get the stock back, (2) the risk that the value of the collateral you hold falls, and (3) issues such as losing voting rights during the lending period, or receiving 'payments in lieu of dividends' instead of dividends, which changes the tax treatment.
That the lending fee is around 0.3% per year for large, liquid stocks and very high for small, scarce stocks, and that the lender faces collateral-decline, borrower-bankruptcy, and voting-right-loss risks, is explained by the Corporate Finance Institute, SoFi, and others.
Your Stock Can Be Lent Out Without You Knowing
Some brokerages, through a 'securities lending service,' lend out customers' held stock and share part of the fee. If you enroll, you can earn a small lending income even while doing nothing.
However, during the lending period there may be constraints on exercising voting rights or selling immediately, and you also take on the counterparty and collateral risks mentioned above. Even if it looks like 'free income,' you should check the terms and risks.
It's also worth knowing that your stock can be used for short selling. In exchange for the lending fee, that stock can be mobilized for a bet on a decline in the company you invested in.
Preguntas frecuentes
Q. Is enrolling in a securities lending service always a gain?
It's true that you earn a small lending fee income, but it's not 'always' a gain. During lending there may be constraints on exercising voting rights and selling immediately, and you also take on risks like borrower bankruptcy and collateral decline. The fee received is often not large, so it's best to decide after checking the terms and risks.
Q. Are securities lending and short selling the same thing?
They're different. Securities lending is the act of 'lending and borrowing stock' itself, while short selling is a strategy of 'selling borrowed stock to bet on a decline.' Because you must first borrow stock through securities lending to short, securities lending is the precondition (back end) for short selling.
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