Similar to renting out your real estate property, you can make an extra income by renting out your stocks. Stock lending is a straightforward and convenient way to earn money from shares that are currently sitting idle in your portfolio.
Stock or share lending involves the temporary transfer of shares, where the borrower pays a fee, usually monthly, to the owner of the shares. Borrowers typically use the rented stocks for trading activities, such as short selling, hedging, and more.
How does stock lending work?
Individual investors can’t usually lend securities among themselves; rather, the service is provided by brokers or dealers. Investors need to complete a securities lending agreement or loan agreement to officially execute stock lending.
A securities lending agreement dictates the lending terms, including duration, interest rate, collateral, and fees. Investors can choose to loan their entire portfolio or just individual stocks.
Depending on the system used by brokers or dealers, once an investor activates a stock lending account, it is visible to other investors and financial institutions who are intent on borrowing stocks.
Once the two parties agree, the borrower is typically required to provide at least 100% of the security’s value as collateral. The collateral may change depending on the volatility.
Why would someone borrow a stock?
Investors or traders can borrow a stock for a host of reasons. Some of the most popular ones are:
- Short selling: It is a common reason for borrowing a stock. If a trader expects the price of a particular stock to drop, they can borrow that stock, sell it and then buy it later at a lower price to make a profit from the price difference.
- Covering failed trades: If a broker or trader fails to deliver the stock on time for settlement, then they may borrow the stock to meet the delivery obligations and avoid penalties.
- Get voting rights: Some firms or investors may also borrow stocks to gain more voting rights, with the intention to influence management decisions.
- Hedging: Big investors and financial firms may use securities lending to offset market exposure due to volatility. For instance, if an investor has a portfolio of stocks but is concerned about a short-term market downturn, he or she can short the same amount of that stock to minimize the impact of downturn.
- Use as collateral: Banks or financial institutions may require lenders to pledge certain securities in order to secure a loan. Such lenders can borrow the securities if they don’t own them.
Earning money from stock lending
There is no fixed amount that a lender can make from lending securities. The payout instead depends on the demand, i.e., stocks with low availability and high demand usually command higher earnings. Interest rates, usually, vary from 0.2% to 5%, but can go up to 100% for heavily shorted stocks.
The lender may also earn from the collateral provider through the borrower. The broker or dealer may invest the collateral provided (if in cash) in short-term securities and share the earnings with the lender. Separately, the fee paid by the borrower is split between the lender and broker.
Furthermore, the duration of loaning securities also impacts your earnings. The longer your stocks are on loan, the more money you make.
Stock lending example
Investor X owns 200 shares (notional value of $20,000) of Company ABC and doesn’t plan to sell them anytime soon. However, X plans to lend the stocks to earn an interest rate of 4%, and thus, creates a lending account with the broker.
Investor Y, who has an account with the same broker, expects Company ABC shares to drop in the short term. So, Y borrows those 200 shares from the broker and sells them at $100 each. After a while, the share price drops to $80. Y buys those shares back and returns them to the broker.
In the transaction, Y makes a gross profit of $20 per share (or $4,000). The lender, on the other hand, earns the fee, which is 4% (or $800; or 4% of $20,000). Depending on the terms, X may pocket the entire fee or share a certain percentage with the broker.
Benefits of stock lending
The following are the benefits of stock lending:
- Extra income: Investors can easily earn extra income on the stocks sitting idle in their portfolio. If an investor owns a heavily demanded stock, then he or she could pocket higher income. Moreover, the extra income generated is without selling the stocks and without losing the ownership.
- Supports short selling: Investors having a bearish view on a stock can use share lending to make a quick profit. The arrangement gets more useful if the stock they want to short isn’t readily available in the open market.
- No counterparty risk: Share lending doesn’t involve any counterparty risk as investors don’t directly transact with each other. Lending securities is typically facilitated by a dealer or broker, who is responsible for the fees and shares.
- No change in ownership and dividend rights: Lending shares don’t breach or violate investors’ share ownership rights. The lender has the right to cancel an existing loan or sell stocks anytime they want. Furthermore, the dividends on the lent stocks are passed to the lender by the borrower.
- No day-to-day management needed: Stock loan programs doesn’t require continuous monitoring from investors. The program, rather, runs on autopilot.
The risks of stock lending
The following are the risks or drawbacks of securities lending:
- Loss of voting rights: By loaning your stock, you lose the voting rights that come with shares. When you loan out a stock, the voting right gets automatically transferred to the borrower as long as they hold the share.
- Not finding a borrower: If you own a stock that is not popular among traders, it is possible that you may not find a borrower, and thus, make no extra money.
- Default risk: Even though there is no counterparty risk in stock lending, the risk of the borrower going insolvent is always there. Brokers or dealers, however, now have high collateral requirements to counter such risks.
- Tax liability complications: Determining tax liability can be difficult in the case of securities lending, especially when it comes to dividends, loan fees and proceeds from the sale of securities. For instance, when you own a stock, the dividend you receive is taxed differently depending on your taxable income and filing status. However, when you loan the stock, you don’t receive the dividend payout fromthe company, rather it is passed to you by the borrower as a cash payment. Such cash payments are taxed at your regular income tax rate, which is usually higher than the tax rate for qualified dividends.
- Loss of insurance coverage: When you buy shares, you get some protection if your broker goes bankrupt. So, in such scenarios, you don’t lose all your investment. However, you lose such insurance coverage when you loan your stock.
Stock lending pros and cons
Pros
- Earn passive income
- Ownership of the stock is maintained
- Borrowers provides collateral, at least 100% of the loaned stocks value
- Ownership and dividend rights remain intact
- Regular monitoring is not needed
Cons:
- Lender loses voting rights on loaned shares
- No guarantee your stocks will be lent out
- In some juristrictions, payments may be taxed differently than dividend payments
Stock lending versus short selling
Stock lending and short selling are two distinct concepts, where the former is a means to earn additional income, while the latter is a trading strategy. We can, however, say that securities lending enables short selling, or short selling is one major reason why investors borrow stocks.
In short selling, a trader expects the price of a stock to drop in the near future. To execute the short sell strategy, the trader sells a stock at a higher price and buy it back later at a lower price to pocket the price difference.
So, the trader borrows the stock using stock lending and then short sell it, with the intention to buy it back later at a lower price. The short seller owes borrowing fees to the broker or dealer, irrespective of the profit (or loss) from the short sale.
Moreover, the short seller faces unlimited risk in case the stock price moves up drastically instead of going down. Lender’s risk, on the other hand, is eliminated or minimized due to collateral requirements and clearing corporations.
How to start stock lending
To initiate stock lending, the primary requirement is selecting an investment platform that supports securities lending. Many popular online platforms offer stock lending services, such as eToro’s stock lending program.
Once you have registered with the broker, you need to enable the stock lending feature from the account settings. You will be prompted to accept the terms and conditions or submit an activation form with the broker.
You then need to submit a request for an eligible stock that you want to lend, including specifying quantity, lending period, and the fee. It must be noted that not all stocks are eligible for lending, and thus, it is important you check the list of approved securities for lending with the broker.
Once your request is submitted and approved, it will show on the brokers’ stock lending system and will be visible to potential borrowers. Moreover, the system will automatically match your request with the borrower who wants the same stock.
Conclusion
Stock lending is a productive investment strategy that allows you to earn from stocks that are currently sitting idle in your portfolio. However, like with any investment activity, securities lending also has its own risks that investors need to be aware of.
Lending securities is a primarily good investment strategy for long-term investors who are not concerned about intraday trading and are confident in their portfolio.
When used wisely, lending stocks can enhance your overall portfolio returns without changing your core positions, as well as support diverse trading strategies and improve market liquidity.
FAQs
How many stocks do you need for stock lending?
Can you lose money from stock lending?
When are you paid for securities lending?
Do you need to pay tax for lending stocks?
References
- Implementing sec securities lending reporting requirements; finra.org
- About stock lending; Robinhood.com
