What it means
When a trader believes a share price will fall, they can borrow the shares, sell them now, and buy them back more cheaply later to return to the lender. This is called short selling, and it cannot happen unless someone is willing to lend the shares.
Stock lending is the market that supplies them. The lender, often a pension fund, insurer or exchange-traded fund, keeps its economic position throughout.
If the shares pay a dividend while on loan, the borrower passes an equivalent payment back, and any rise or fall in price still belongs to the lender. What the lender gives up is the right to vote the shares while they are out.
Because the borrower might fail to return the shares, the loan is protected by collateral, meaning cash or other securities worth at least as much as the loan. The collateral is usually set at a little above 100% of the shares' value and is revalued every day.
If the share price rises, the borrower tops up the collateral. Most lending runs through an agent, such as a custodian bank, who finds borrowers, handles the paperwork and takes a share of the fee.
Shares that are hard to borrow, perhaps because many traders are betting against them, command higher fees than widely held, easy-to-borrow shares. The business case is simple income.
A large fund might earn only a small fraction of a per cent a year on its lending programme, but across billions of dollars of holdings that income can offset a meaningful part of the fund's running costs. It is not free, however, because the lender takes on counterparty risk and collateral reinvestment risk.
A common variant is a loan that can be recalled. The lender can usually ask for the shares back, for example before a shareholder vote, though the borrower then has to find the shares elsewhere or close out its position.
In practice
Real-world examples
Example 1
A pension fund holds $400,000,000 of listed shares for the long term. It signs a lending agreement through its custodian bank and, with only part of the portfolio actually on loan at any time, earns extra income each year that reduces its net costs.
Example 2
A hedge fund thinks a retail company is overvalued and wants to bet on a fall in its shares. It borrows $3,000,000 worth of those shares, posts cash collateral, sells them in the market, and later buys them back and returns them after the price drops.
Example 3
An exchange-traded fund manager reviews its fund's expenses. The manager notes that lending fees earned on the underlying shares are credited back to the fund, which helps to narrow the gap between the fund's performance and its benchmark index.
Think of it
Imagine you own a rare classic car that sits safely in your garage most of the week. A film production company asks to rent it for a weekend shoot, leaving you a large cash deposit and paying you a rental fee. You get paid for an idle asset, and they get what they need for a specific job.
Formula
Calculation
Lending income = Value of shares lent x Annual fee rate x (Days on loan / 365)
A fund lends shares worth $2,000,000 for 73 days at an annual fee rate of 0.50%. The full-year fee would be 2,000,000 x 0.005 = $10,000. Because the loan lasts 73 of 365 days, which is 0.2 of a year, the fee earned is 10,000 x 0.2 = $2,000. If the lending agent keeps 15% of this, the agent receives 2,000 x 0.15 = $300 and the fund keeps $1,700.Case study
Seen in the real world
Cedarfield Retirement Trust is an illustrative, fictional pension scheme with $800,000,000 invested in shares. Its trustees were uneasy when the investment manager proposed a lending programme, because they assumed lending meant giving shares away.
The finance lead explained the structure. Collateral worth 102% of every loan would be held in a segregated account, valued daily, and the trust could recall any shares within the standard settlement period.
The programme was launched with a cap of 15% of holdings on loan at any time. In this illustrative story the trustees were satisfied once they saw that the main risks, a borrower default and poorly invested cash collateral, were limited by the written rules.
Watch out
Common mistakes
- Assuming a lender stops owning the shares during the loan, when the lender keeps the price exposure and receives an equivalent of any dividend.
- Ignoring collateral quality, since cash collateral that is reinvested in risky assets can lose money even when the borrower behaves perfectly.
- Forgetting that lent shares cannot be voted, which can matter a great deal before an important shareholder meeting.
Questions
People also ask
Can a lender get its shares back early?
Usually yes, because most loans are recallable, although the lender should check whether the agreement sets any notice period.
Who makes the money in stock lending?
The lender earns the fee, the agent takes an agreed share of it, and the borrower pays the fee in exchange for being able to short sell or cover a trade.
Is stock lending the same as a margin loan?
No, a margin loan lends cash to an investor to buy shares, while stock lending lends the shares themselves to someone who needs them.