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What is Securities Lending? Also known as Lend and Earn at SoFi Hong Kong

What is Securities Lending? Also known as Lend and Earn at SoFi Hong Kong

Securities lending is the business of investment firms loaning out shares to borrowers as a way to collect additional revenue on stocks that otherwise would have sat untraded in their portfolios. Meanwhile, the borrowers of the shares are often short sellers, who give collateral in the form of cash or other securities to the lenders.

Lenders tend to be pension funds, mutual funds, sovereign wealth funds and exchange-traded fund (ETF) providers, since these types of firms tend to be long-term holders of equities. Brokerages can also practice securities lending with shares in retail investors’ brokerage accounts. Securities lending helps such firms keep management fees down for their investors.

The practice can extend beyond equities to bonds and commodities. Securities lending has become more popular in recent years as price wars drove down management fees to near zero and investment firms sought other sources of revenue. 

Securities lending is useful to investors who are shorting a stock, because they have to borrow shares in order to put on their bearish positions. Critics argue that the practice comes at the expense of fund investors, since investment firms forgo their voting rights when they loan out shares. They might also try to own stocks that are easier to rent out. Other concerns include a lack of transparency and an increase in counterparty risk.

How Securities Lending Works

Here’s a closer look at how securities lending works:

  1. Institutional investors use in-house or third-party agents to match their shares with borrowers. Such agents receive a cut of the fee generated by the loan.
  2. The fee is agreed upon in advance and typically tied to how much demand there is for the lent-out security.
  3. The institutional investor or lender often reinvests the collateral in order to collect additional interest or income while their shares are out on loan.
  4. Borrowers tend to be other banks, hedge funds, or broker-dealers, as well as sometimes other lending agents. When the borrower is done using the shares, they return them back to the lender.
  5. If the collateral posted was in the form of cash, a proportion of the revenue earned from reinvesting is sometimes given back to the borrower.

It’s important for individual investors to know that for dividend stocks, they would get some form of payment from the borrower, rather than the dividend itself. This payment may be taxed at a higher rate than a dividend payout.

Securities Lending and Short Selling

In order to short a stock, investors first borrow shares. They then sell these shares to another investor or trader, with the hope that when the stock price falls, the short seller can buy them back and pocket the difference before returning the loaned shares.

In securities lending, a share can only be lent out once, but when the borrower is a short seller, they can sell it, and the new buyer can lend it again. This is why the short float–the percentage of the share float that is shorted–can rise above 100% in a stock.

The fee generated by renting out shares depends on their availability. A small number of stocks tend to account for a large proportion of revenue in securities lending.

Criticism of Securities Lending

In December 2019, Japan’s Government Pension Investment Fund announced that it will halt securities lending, saying the practice is not in line with its goals as a long-term investor. The world’s largest pension fund cited a lack of transparency on who is the ultimate borrower of the loaned securities, as well as why they were borrowing.

This became a bigger concern for investors after the “cum-ex” scandal in Germany, where borrowed shares were used in a tax evasion scandal.

Another one of the biggest criticisms of securities lending is that voting rights of the actual stock transfers to the borrower. This challenges the traditional model where institutional investors vote and push for change in companies in order to maximize shareholder value for their investors. Money managers can recall shares in order to cast a vote in an upcoming shareholder meeting. But there are concerns they don’t and it’s unclear how often they do.

Another concern has been that securities lending programs incentivize money managers to own stocks that are popular to borrow. A 2017 academic paper updated in November 2020 found that mutual funds that practice securities lending tend to overweight high-fee stocks and then underperform versus funds that do not rent out shares.

Potential Risks of Securities Lending

A concern is the increase in counterparty risk. Let’s say for example a short seller’s wager goes sour. If the shorted stock rallies enough, the short seller could default and there’s a risk that the collateral posted to the lender isn’t enough to cover the cost of the shares on loan.

Separately, the lender, whether they’re a pension or an ETF provider, typically reinvests the cash collateral in order to earn additional interest. Bad bets could cause the value of the investment to drop. During the 2008 financial crisis, some funds lost money from reinvesting the collateral in risky assets.

The Takeaway

Securities lending is a small but reliable source of revenue for institutional investors and brokerage firms, who get to rent out shares that otherwise would have sat idly in portfolios. The practice has ramped up in recent years as management and brokerage fees have shrunk dramatically due to competition and the popularity of index investing.

Proponents argue that securities lending helps pay for the cost of running money management funds and brokerage platforms, which in turn allows investors to benefit from lower fees.

Critics argue that a loss of voting rights and a lack of transparency are problematic, as well as the risk that securities lending can distort mutual fund portfolios to overweight stocks that are popular to borrow, hence more likely to generate revenue.


About SoFi Hong Kong

About SoFi Hong Kong

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