Stock Lending: Pros and Cons
Stock lending, also known as securities lending, is a feature offered by some brokerage platforms that allows investors to lend their shares to other market participants, primarily short sellers. In return, investors receive interest payments, offering a way to generate passive income without having to sell their holdings. Think of it like renting out your stock to someone else for a period of time.
However, while this might seem like an effortless way to earn extra income, it comes with its own set of complexities and risks that investors should carefully consider.
How Stock Lending Works
When an investor participates in a stock lending program, their brokerage lends out shares from their portfolio to borrowers. These borrowers pay interest for the privilege of borrowing the shares, which is where the investor’s earnings come from. The brokerage typically facilitates the entire process, handling the lending agreements and securing collateral from borrowers to mitigate risk.
Lending Rates
The borrower of the stock pays an interest rate which can vary significantly on a day to day or even hour to hour basis. They can be as little as an annualized 0.25% or 20%+ depending on several factors:
- High Demand Stocks: Stocks that are in high demand due to market action, headline news, or other world events
- Heavily Shorted Stocks: Stocks that are being heavily shorted by market participants.
- Lower Supply of Shares: Stocks that have a limited supply of tradable shares and are thus harder to get a hold of.
- Volatility: Volatile market periods.
Typically, a brokerage firm will take a substantial cut of the gross lending rate.
Who is Borrowing Stock and Why
The primary reasons for borrowing stocks are for short-selling, hedging, leverage. and market liquidity. The most common borrowers of stock are:
- Hedge Funds: Hedge funds frequently borrow stocks to execute short-selling strategies, aiming to profit from declining prices. They also use borrowed shares for arbitrage opportunities, hedging against market risks, and employing complex trading strategies.
- Institutional Investors: Large financial institutions, such as pension funds, mutual funds, and insurance companies, may borrow stocks to hedge their portfolios, manage risk exposure, or engage in liquidity-driven strategies.
- Market Makers and Broker-Dealers: Market makers borrow shares to ensure liquidity in the market by facilitating efficient trade execution. They help reduce bid-ask spreads and maintain smooth market operations by temporarily holding stocks to match buyers and sellers.
- Proprietary Trading Firms: These firms, which trade using their own capital rather than clients’ funds, borrow stocks to leverage their positions, execute arbitrage strategies, or hedge their exposures in various market conditions.
- Options and Derivatives Traders: Traders who deal in options or other derivatives may borrow stock to hedge their positions, especially when they have sold call options and need to cover potential assignments.
Pros of Stock Lending
Boost in Income Generation: Investors earn interest or lending fees on their stocks, providing an additional revenue stream without selling their shares.
Little Effort Required: Once enabled, the brokerage handles the lending process, making it a passive feature that doesn’t require active management.
No Impact on Ownership Benefits (in Most Cases): Investors typically retain economic benefits, such as stock price appreciation and dividends (though dividends may be replaced by substitute payments).
Cons of Stock Lending
High Probability, Variable Impact
Dividend Treatment Changes: You no longer receive dividends from the position but instead receive Substitutes Payments. Substitute payments received in place of dividends may be taxed at a higher rate. If the lent stock is held in a taxable account this could mean a higher tax rate than dividends.
Limited Control Over Lending Terms: Investors have little say in which shares are lent and at what rate. Additionally, brokerages could take a large percent of the interest charged leaving the investor with relatively little.
Potential Impact on Stock Price: Lending shares to short sellers could contribute to downward pressure on the stock’s value.
Limitations on Selling: Lent stocks may be restricted on when you can sell them resulting in losses if you are trying to sell while they are lent out and the price falls.
Limited Impact
Loss of Voting Rights: Borrowed shares temporarily remove the investor’s ability to vote in shareholder meetings. If you don’t vote or have few shares where your vote is not significant, then this won’t matter as much.
Low Probability, High Impact
Counterparty Risk: Despite collateral protections, there is always a potential risk of borrower default.
While stock lending can provide an additional revenue stream, it may not be suitable for every investor. Those who prioritize shareholder rights, consistent dividend income, or who have concerns about contributing to short-selling activity may wish to avoid it. On the other hand, long-term investors who are comfortable with potential risks and fluctuations in earnings may find it a beneficial way to enhance their returns.
Ultimately, before enrolling in a stock lending program, it is essential to review the brokerage’s terms, understand the revenue-sharing arrangements, and assess the potential tax implications of substitute dividend payments. By weighing the pros and cons, investors can determine whether stock lending aligns with their broader financial strategy