Stake Academy Wall St: Stock Lending

One of the lesser known, alternative sources of income for brokers is called securities lending (known as Stock Lending on Stake). What is securities lending, and how does it impact you, the investor? Let’s dig in and find out.

Back To Basics

Securities lending is when a broker loans out stocks owned by their customers to a borrower. In return, a fee is paid by the borrower to the broker. Most of the time, this happens without the customer knowing or being impacted and is one of the main ways brokers make money. For example, JP Morgan, InteractiveBrokers, Robinhood, Vanguard and many others have programs that either facilitate lending or lend out the securities under their control. Securities lending is so prevalent the U.S. Securities and Exchange Commission (SEC) wrote an explainer page back in 2014 stating:

“Securities lending is a well-established practice by institutional investors such as U.S. open-end and closed-end investment companies (“funds”), insurance companies, pension plans, and college endowments… to generate additional income”.

Lending In Practice

When it comes to securities lending there are essentially three key parties involved: the lender, the broker and the borrower.

The lender is the person that owns the underlying asset, these stocks are held in their name by the broker.

The broker matches the borrower’s needs with one of its lender’s positions. Typically, the borrowers are institutional investors or banks. As compensation for facilitating the loan, the borrower pays a fee to the broker. You can think of this as the stock market’s equivalent of a bank paying its depositors interest.

Historically brokers have kept 100% of the loan fee, however, in the case of Stake, we have cut the lender (the Stake customer) in on the deal, creating passive income for the owner of the stocks.

Why Not Buy The Stock?

As stated, Securities Lending is common practice, but you’re probably wondering why not just buy the stock? Why borrow it from someone else? The answer is there are a number of different strategies that work only if you borrow the stock. The two types we will briefly cover are shorting and index arbitrage.

Shorting is the most commonly known reason to engage in securities lending, but don’t be fooled into thinking that you are hurting your position. True, selling a stock short can have a negative effect on the price and does involve borrowing shares and selling them to open the position (it is closed by rebuying the sold shares). However, the U.S. is an incredibly liquid market and it is highly unusual that any retail investor would be able to prevent or limit short selling by refusing to take part in a securities lending program. For more information on short selling click here.

Another common reason to borrow securities is index arbitrage. This is when you take advantage of the difference between the price of an index’s futures and the stocks themselves. You see, in theory the price of, say, the S&P 500 should be equal to the market cap-weighted value of all of 500 stocks. If the total of the individual shares is cheaper than the price of the future, an arbitrage strategy would theoretically generate a risk-free yield, but requires access to securities lending. For more information on stock arbitrage and securities lending strategies, check out this blog post by Pierpoint Financial Consulting.

The Risks

Still, the market is a fickle beast, and the headlines are often splattered with black swan events and titans falling. So surely lending out your stock has risk? Yes, of course, it’s not risk-free; nothing is in the market. This is why the U.S. Securities and Exchange Commission (SEC) has instituted collateral requirements for securities lending.

This means you’re protected if a borrower can’t return your stocks. The SEC requires borrowers to provide assets (not always cash) of at least the same value as the borrowed stocks, which brokers are required to set aside in a separate account. The collateral is updated daily. Stake on the other hand, requires borrowers to provide 102% collateral in cash. If the stocks return as normal, the collateral returns to the borrower.

*U.S. stocks are available for Stock Lending, but you’ll be able to opt out at any time (Wall St Account > Settings > Trade settings > Stock Lending settings).