Sometimes you look at something new that seems complex and think, wow, that’s a lot — I’m not gonna bother. Like when I was signing up to try rock climbing. The website was so complicated, about 25% of the way through I gave up. I thought, is it me? Either way, I decided the competitor two blocks away with a simple site would have my business.

There are things in finance and investing like that, too. Some are not crucial enough to successful investing to spend time on unless you want to. But others might be worth a little study. One, in particular, is stock lending. 

In truth, it’s something I’ve known about for years — as a way institutions and banks make additional money on assets they hold or manage. As such, I didn’t think about it too much other than to understand the potential background risk from it when investing in a mutual fund or ETF. But when I learned that people could do it too, I thought, hmmm… let me look into this. 

Here are my notes, or where I got to so far, with the help of a friendly colleague who has been doing it for decades.

OK, friend, what is stock lending?

Stock lending is when you allow others to borrow stocks you own, and in return, you get paid a fee, typically monthly. You are “renting out” your stocks for a fee.

Umm, ya know I’m going to ask this quickly — what’s the catch? How do I know I will get my stocks back if I lend them out?

This is where I think a lot of people drop off, like your rock climbing sign up. And I get it — it seems like there is something going on here that might make it not worth it. 

You see financial institutions and other market participants borrow stocks to 1) facilitate trade settlements and 2) sell stocks short. To cover the lender, a lot of places that create this type of program hold funds in cash-like investments (collateral) to protect the value of loaned stocks, since SIPC protection no longer applies to stocks on loan. This is so the lender would get paid the value of loaned securities in cash if the company lending your shares out filed for bankruptcy and couldn’t return the stocks borrowed. The borrower is contractually obliged to return the securities on demand or at the end of the agreed loan period, while during the loan period, the lender retains ownership rights of the security. So any dividends/interest payments are passed along — directly or through a “payment in lieu.”

Explain “facilitate trade settlements” and “sell stocks short.”

Re: facilitating trade settlements, there's a reason most firms refer to Securities Lending as Securities Finance. The vast majority of securities lending is done for funding purposes.  Along these lines, right now buying and selling stocks take place with a T+2 settlement. That means while you own something or sell something right away, all the tangible operations that take place to transfer physical trades happen over a two-day period. This exists because of the time difference between Asia and NY, physical settlement, ETF creation and redemption, ADR release, market making, etc. In many cases, Securities Lending is used to facilitate these functions. The ability to borrow to avoid settlement failure is vital to ensure efficient settlement. As an example, maybe I want to create an ETF, but if I don't want to own XYZ stock, I can borrow it instead. 

Re: sell stocks short, this is when for a multitude of reasons, an investor sells a stock without owning it. As such, they borrow shares in order to sell them. 

My natural next question is, why would I help someone sell a stock I hold? 

Well, one thing to remember is that on the opposite side of every short sale is a buy. At the end of the day, stock prices move due to the number of buyers vs. sellers in any market.

But in the long run, whoever is shorting anticipates the stock price to fall, right?

Not necessarily — that assumes every short sale is directional only. Yet, there are a slew of reasons for shorting that have nothing to do with sentiment on one specific stock. There are many investing strategies that don’t take a specific negative view on one stock: special situations, market neutral strategies, index arbitrage, convertible arbitrage, relative value trades, delta neutral trades, etc. Plus, even for directional trades, if it were that easy to make money — just short and the stock follows suit — everyone would do it. Similar to how you can buy a stock and lose money, you can short a stock and lose money. If you are long (own) a company, because you believe in it, then short selling won’t affect that. Short selling by itself doesn’t drive a stock price down — consensus and market sentiment do that.

From experience, there are plenty of portfolio managers that short stocks against longs, where their motivation is to hedge a part of the business they don't care about or make a relative bet between two companies, rather than an outright one.

OK, so the reasons why someone would borrow stock vary and are not necessarily to invest against you… but something can go wrong, right?

Of course there is risk in it. The main risks are:

• The borrower of your stock becomes insolvent — and not all the borrowers, but the borrower facilitating the lending.

• The value of the collateral behind lending falls below the cost of replacing the securities that have been lent. 

• The securities being lent are delivered to the borrower before the collateral is received.

• The lender’s legal agreement does not provide full protection in the event that the borrower defaults.

But the number of times this has happened in history have been rare. And remember, there is often collateral, covering 100% or more of the value of the securities borrowed, set aside to cover these risks, which are often invested in almost cash-like investments like very short-term treasury bonds. 

Do I still get my dividends if my stocks are lent out? 

Most of the time, stock lending programs are set up such that the stocks on loan are returned for dividend record dates — so that dividends are received as normal to the lender. However, if this doesn’t happen for some reason, the stock facilitator would likely provide cash equal to the amount of the dividend. This is called a manufactured dividend, or “payment in lieu.” Also, there should be no difference in the timing of receiving the cash between the two.

Ah, that’s what you meant before by payment in lieu. What if I have DRIP (dividend reinvestment program) enabled? Would that cash received get re-invested?

It should — usually the cash received will be reinvested automatically, whether it's from the actual dividend or manufactured dividend. 

Last thing to note on the topic of dividends is that the tax treatment is different between the two types. A dividend tax rate is determined by Federal and state laws where a qualified dividend is taxed at a 20% Federal rate. A manufactured dividend is considered to be like interest so the rate is under ordinary income vs. dividend income. What the difference is, if any, depends on your income, but it can be more. Of course, you should always speak with a tax professional to understand your specific tax sitch. 

Anything else I should be asking you about?

There’s probably one more thing to understand. While any stock(s) are loaned out, you lose shareholder voting rights for them. This means you won’t be able to vote on company matters if your stocks are on loan. However, if you disable stock lending or your stocks are returned to you, you’ll regain shareholder voting rights.  

OK, so how much can I expect to earn if I lend my stocks out?

Like a lot of things, this goes back to the principle of supply and demand. Whether or not your stocks are lent out and how much you can earn really depends on the stocks and the demand to borrow them. Like a lot of things, demand and supply drives prices.

One thing to look at is short interest % on a stock, which tells you how much of the available stock is being shorted. Just because you lend it out doesn't mean it's heavily shorted. And the amount you earn from lending it out will reflect that. E.g., lending out shares of an S&P 500 ETF may pay very little, whereas you could earn much more when lending out shares of a small biotech company (%s can be very high). In general, once there is a lot of stock borrowed, it can become “hard to borrow” and pay quite a bit to lenders. 

Thanks, friend.

So while it's true that stock lending may not be for everyone, when I consider the benefits against the risks, it does seem to make sense. After all, when you buy an ETF that lends out their securities, many times it’s not your choice and you don’t get any of the benefits, whereas in a stock lending program, you get to decide. 

I’d consider that over a complicated website for a leisure activity anyday.