Getting Income from Fully Paid Securities Lending

When it comes to earning income from stock, most people probably think of price appreciation: buying low and then hopefully selling high. But some investors also earn extra income by lending out shares of stock they own. 

Shares aren't just bought and sold. They are also borrowed and loaned. For some strategies, having temporary control of stock shares matters. The investors get to retain ownership of the stock and earn additional money through interest payments from the borrowers. It's a way for investors to add extra income to a portfolio while still benefiting from price appreciation.

Lenders also fill a gap for traders whose strategies require borrowing shares of stock, like short sellers, who try to profit from borrowing and selling shares in hopes of repurchasing them at a lower price. This adds to the dynamism of the financial markets. Short selling is the most common reason for borrowing shares, but it's not the only one. 

Lending securities can help make modern financial markets function more efficiently by creating liquidity and ensuring that trades clear. Investors who hold shares in non-employer retirement accounts may be invited to lend certain hard-to-borrow securities they hold to the marketplace for borrowing. (Note: Employer-sponsored retirement plan accounts like 401(k)s are not eligible under the Employee Retirement Security Act rules.)

When an investor wants to borrow shares, they place a request like an order to sell short through their broker. (Institutional traders sometimes go through lending agents, such as a hedge fund that makes its shares available to borrowers.) The broker will then check the inventory of available shares to loan out both internally and externally to match up potential borrowers with share owners. Demand changes frequently and not every security has the liquidity to facilitate these transactions. When there's a match, the loan is arranged, and the shares are made available to the borrower. The broker can charge interest on the loan at a rate that varies with the market rate of interest and the demand for the shares. The shareholder receives a portion of that interest, paid to their account.

To ensure the loan is repaid, the borrower must put up collateral equal to or exceeding the amount borrowed—usually cash, Treasuries, or a Letter of Credit. Collateral for fully paid loans is posted and held in a custodial account during the life of the loan to protect the lender. When the borrower returns the shares, the broker returns the collateral. 

While the lender retains full ownership of the shares, there could be downward pressure on the stock price if used to facilitate a short sale. Lenders also temporarily give up some shareholder rights on loaned securities, and their tax treatment on dividends paid during the course of the loan may be different. Dividends are paid out to the borrowing party, who then forwards a cash payment in lieu of dividend to the lender. Cash received may be subject to different taxation than standard dividends. Voting rights also go to the borrower for the duration of the loan and is a reason some people want to borrow shares. It's important to note that not all securities are eligible to loan. Your broker may have specific appropriateness and approval requirements in order to be eligible to enroll in its fully paid lending program, and not everyone will qualify. Check with your broker for full details about availability and eligibility requirements of the program.

Every day, people borrow and lend stock shares. Some reasons are common; others are more esoteric. Lending shares to borrowers helps create more liquid markets for investors with many different strategies. Here are some groups that borrow stock:

• Short sellers look to profit from a decline in stock prices by borrowing shares and selling them. They hope to repurchase the shares at a lower price, keeping the price difference as their profit and then using the new shares to repay the loan. If short sellers can't borrow shares, they can't place their trade. It's important to note that short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account. There is also no guarantee a brokerage firm can continue to maintain an investor's short position; it may be closed out by the firm without regard to profit or loss.
• Option traders may short stocks to hedge positions.
• Some activist investors may be looking to increase their voting position in a company. One way to do this without buying more shares is to borrow them, then add those votes to the votes they already have. This process is controversial, though, and the SEC is considering new regulations that might restrict this.
• A broker who might borrow if they're running into clearing issues. Equity trades must clear the next business day, meaning sellers must relinquish their shares and buyers must receive them. On occasion, one of the parties may have trouble finding and delivering the shares on time, so the seller might borrow if that happens to ensure the trade closes on time.

Securities lending allows lenders to earn additional income while still owning the shares, but because these shares can be used for a short sale, there could be downward pressure on the stock price in addition to how lending potentially affects dividends and voting rights.

Lenders can request their shares be returned and/or sell the loaned security at any time. If the shares are not delivered in time, then the cash collateral is used to buy in the borrower to ensure delivery for the sale.

The 2008 financial crisis exposed another risk, which new SEC regulations helped reduce. At that time, many cash collateral accounts invested in money market securities, some of which defaulted or declined in value. Under the new regulations, cash collateral accounts can only be invested in Treasury securities.

Lending shares can help create liquidity in the market and is a way for longer-term investors to increase their returns. But it's important to remember that the stock price may go down, so they should be comfortable with this risk. There are other limitations too, such as potential changes to voting rights and the way dividends are paid. Of course, fully paid lending isn't appropriate for everyone. Investors with very short-term liquidity needs or who do not understand the risks should not consider the program. Still, for those who qualify, lending can be an attractive option for a little extra income.