Fully Paid Securities Lending

Understanding Securities Lending

Securities lending is a common strategy used by institutional and sophisticated investors to generate additional income in their portfolios. Securities lending is when an individual or institutional investor (the lender) temporarily loans securities to a financial institution, such as a brokerage firm, bank or hedge fund (the borrower). The loan is usually facilitated by an intermediary, known as the lending agent or clearing broker. All parties enter into a loan agreement that covers the terms of the loan, how the lender is paid, how the revenue will be shared as well as other provisions that should be considered before entering into such an agreement.

How Securities Lending Works

What is a loan agreement?

The loan agreement provides an overview of the terms and conditions related to the securities lending borrow-and-loan transaction as well as the remedy due to the borrower and lender in the event of a default. The agreements also cover the type of securities that can be loaned, which may include U.S. and foreign stocks, corporate bonds and government debt and may specify that the securities are "fully paid for," meaning that they are owned outright by the investor, and there is no margin held by the clearing broker.

Why are securities borrowed?

There are many reasons a financial institution may want to borrow securities, but generally it is done to support a trading strategy, cover short sales or satisfy customer possession and control requirements. Most borrowers seek securities that are considered “hard to borrow,” meaning they are difficult or unavailable to borrow due to limited supply. Can investors sell loaned shares?

Most securities lending programs allow investors who lend their shares to continue to trade as usual and sell them at any time without prior notice.

Do investors receive dividend payments on loaned shares?

While investors do not receive dividend payments directly on the securities that are borrowed, securities lending programs traditionally offer substitute payments for dividends. However, investors may lose proxy voting rights on shares that are out on loan.

How is the loan secured?

The borrower provides collateral for the loan—usually cash—to protect the lender in the event of the borrower’s default. To protect investors, cash is usually deposited on their behalf into a special reserve account protected by the Securities Investor Protection Corporation (SIPC®). However, you should consult the loan agreement for specific information.

How is the investor paid?

Securities lending provides a relatively easy way to gain incremental revenue on an existing portfolio. The borrower pays a loan fee for the securities that are borrowed. The lender receives the majority of the loan fee, and the remaining portion of the loan fee is shared with the lending agent or clearing broker and often the borrower’s broker-dealer. This fee will fluctuate based on market demand and securities will only be borrowed for a purpose (a loan or delivery need). Some lending agents or clearing brokers may also pay the lender a portion of the interest earned on the cash collateral in the account.

What are the potential risks?

Securities lending is not appropriate for all investors. Reclassification of dividend income from loaned securities may cause tax ramifications, and proxy voting rights on these securities are forfeited. In addition, loaned securities are not protected by SIPC. However, the cash collateral received for the loaned securities is usually protected by SIPC. Enrollment in a securities lending program does not guarantee that securities will actually be borrowed. Investors are encouraged to consult their tax advisor before participating in a securities lending program.

What are the potential benefits?

The main benefit of securities lending for investors is that it can help them to potentially generate additional income on securities they already own. There is also no cost to participate in these programs, and the investor does not usually have to do anything beyond sign the initial loan agreement. If securities are borrowed, loan fee payments are usually made automatically, often monthly, and investors receive substitute payments for dividends on loaned shares.

How can investors participate?

Investors should talk to their advisors to see if their firm offers a securities lending program. To participate, investors will need to read and sign a loan agreement. Please keep in mind that most programs have eligibility criteria, such as a minimum asset level that must be in the portfolio to participate in the program.

Are all securities lending programs the same?

Please keep in mind that securities lending programs will vary and investors should consult the loan agreement for details.