A Guide to Securities Lending
What Is Securities Lending?
In any market, investors are always looking for the next edge. If I were to don my pinstripe suit for a moment and flash a Wharton degree in your face, I’d say that investors are looking for “new ways to generate alpha.”
Whether it’s complicated options trading, long-term buy and hold strategies, or becoming the next Jim Simons, investors look for ways to increase returns consistently year-over-year. However, there’s one often overlooked method that might be right in front of you: securities lending.
Defining Securities Lending
So…what is securities lending? Securities lending is the act of allowing your brokerage of choice to loan out the securities in your portfolio (stocks, bonds, ETF’s, etc) to other investors in exchange for upfront or interest payment or an interest rate fee paid to you over the course of the borrowing term.
What is Short Selling?
So short selling. Short selling is the act of borrowing against shares in order to sell for a net profit from the spread. Complicated, right? But why are we thinking about short selling?
This is a pretty high-level concept that actually might take a pinstripe suit and a Wharton degree to truly master, but here are the fundamentals if you want to channel your inner Bobby Axelrod:
Let’s say that you think there will be a surplus of iPhones in the immediate future, lowering the value of each unit. You know a friend with an iPhone, so you offer to borrow it from him for a fee. You give him a small collateral, and pay him 10 cents per day in fees for his troubles. You immediately turn around and sell that iPhone to someone else for $10. Now you have $10 in cash, but you still owe your friend one iPhone. Well, your prediction comes true and iPhones fall to $5 in value. You buy the iPhone back for $5, then give it back to your friend that originally lent you the first one. You now owe nothing to anyone, and you walk away with $5 in cash, minus the fee you paid to borrow your friend’s phone.
That, my friend, is short selling. You’re betting on a security to fall in value, because the shares you’ve sold in that company aren’t actually yours, and you’re hoping to collect them back at a lower value, pocketing that spread as profit.
Why Does Securities Lending Exist?
As you might imagine, securities lending has been around for as long as people have tried to squeeze every last cent out of their investments. While there is no formal “start date” for the practice, it goes back far enough that the New York Stock Exchange had to shut down their public “loan post,” which served as an in-person securities lending stand, in 1933 over pressure that they were promoting short selling too much to the general public..
Securities lending truly began in the 1960’s, when traders in London began to take advantage of new runs on investors pouring into short sales. From there, the toothpaste was out of the tube. Securities lending, as a business, was in full swing. And by “full swing,” I mean that RBC estimated in 2020 that there is over $30 trillion in securities enrolled in lending programs around the world.
Why Would You Lend Securities?
Extra cash! That can be generated by lending your securities to someone that is looking to execute a short sale, as described in the iPhone example above. Additionally, thanks to fixed fee rates dependent on security demand, it’s a lower risk way to drive a bit of extra cash that you can count on.
If you’re a big bank or financial body, however, then securities lending takes on a bit of a new meaning: liquidity. Take for example the European Central Bank. Since 2015, the ECB has been purchasing billions in public bonds, that they then lend out to other investors at a fixed fee of 5 basis points for securities, or a 20 basis point discount rate for collateralized cash. Essentially, this accomplishes two missions for the ECB:
1. To become a market maker for public bonds, and
2. To drive additional revenue to the balance sheet.
The Downsides to Securities Lending
In the case of the individual, there do exist some downsides to securities lending. One major downside is: what if the borrower goes bankrupt? Do you think you’re getting your money if that happens? It’s unlikely, and all you’ve done in this instance is briefly have a hole in your portfolio.
Another downside to this program is: what if the collateral is less than the value of the shares loaned in the immediate future? If you loan your shares out at $10, then they jump to $20 while they’re loaned out, then drop back to $12 when you get them back, then you’ve missed out on some serious unrealized gains.
How Do I Lend My Securities?
The harsh truth is - you already might be. While some brokerages make a big deal about allowing their users to enroll in securities lending, other brokerages do it without letting you know first. How are they able to do this?
Well, remember when you signed up for your brokerage account and there was that thing you scrolled to the bottom of and pressed “I Accept” so you could get to your YOLO options trades quicker? Well, that’s called the “Terms and Conditions,” and many brokerages include your consent to lend securities within that document. The unfortunate truth is, you likely already gave your consent unknowingly in that document.
Your consent also might be located in the hypothecation agreement you have to sign if you choose to open a margin account with your brokerage. Between the Terms and Conditions, hypothecation agreement or your expressed consent form, you’ve likely yelled consent in a few different ways to your brokerage of choice.
If you do discover that your brokerage is lending your securities and it’s not something you’re comfortable with, the next step could be switching brokerages. Do some research to find the brokerage best suited to your wants and needs, and then contact them to roll your funds over to a new account. Many brokerages take care of this either for free, or for a small fee.
A previous version of this article was originally published on www.fennel.com.