07 September 2022

Spotlight on: Stock lending

Spotlight on 2022v1

With the rise of retail share trading and easy to use online investment platforms, some features of share ownership previously only available to merchant banks and brokers are now being offered to everyday, smaller-scale investors.

One of these features is the ability to lend out the shares you own to other investors. These investors pay a fee to use them for other, more sophisticated (and riskier) activities, like short selling. Stock (or securities) lending is now being offered to retail investors in New Zealand. It’s fairly new to our market, and if you are thinking about participating, it’s important you understand how it works and what the risks are.

What is stock lending?
Simply put, stock lending involves an investor lending their shares to someone else, for a fee. It’s sometimes described as a form of ‘passive income’ where investors can earn money from their shares without even having to do any trading or wait for dividends to be paid out.

How it works
In most cases an investor turns on the stock lending option in their account settings, and the platform then offers up the shares to anyone (usually an institution) that wants to borrow them. When someone is found who wants to borrow the shares, a fee is charged. Some of that fee is passed to the original investor. This portion of the fee might be in the 15% - 20% range for online platforms (this should be clearly disclosed).

Financial institutions and other market participants borrow shares for various reasons, including “short selling”.

The owner of the shares can still sell them at any time. The share price goes up and down as normal. Dividends are still earned, but they’re passed on by the person who is borrowing the shares to the original owner of the shares.

Offering this service is a way for the retail share platforms to earn more income from fees. They pass a small portion of that fee to the original shareholder. And while it’s new to New Zealand online trading platforms, the practise of lending out shares is pretty common for the big share brokers.

There are some managed funds in New Zealand that have the option to participate in stock lending. This should be disclosed to you.

“Earning some extra money by allowing your shares to be borrowed is something new for many investors – so before you agree to it make sure the risks and returns are properly explained and you understand what’s happening.
Ask questions and check that you’re getting a fair deal.
If you’re uncomfortable with your share of the return for taking the risk of someone else using your property, then don’t allow a platform to lend out your shares.”
Paul Gregory, Director Investment Management, FMA.

What is short selling?
Short selling is where investors borrow shares and then sell them, assuming they will soon go down in price.

The short selling investor hopes to buy the shares back at a specific date in the future, when they hope it’ll be cheaper. They then return the shares to the original owner along with a fee.

Because they are using borrowed shares that they haven’t had to pay market prices for, a short seller can get big returns, but it’s a high-risk practice and can trigger losses many times the amount the trader is hoping to earn. It is legal to short sell in most markets, but there are regulations around it, particularly in the US.

Most of the short selling of shares owned by New Zealand retail investors is limited to those in US-listed companies.

What if something illegal is done with my shares?
There’s no liability for the original owner if anything illegal or that breaks market rules is done with the shares while they’re out on loan.

Can short selling damage the company that I’ve invested in?
Whoever borrows your shares is likely to hope that the company’s share price falls.

If you’ve bought into a company because you support its mission or believe in its prospects, lending your shares out means they might be used by an investor who profits if the share price falls. Consider if you are comfortable with this approach.

Some experts consider that short selling can be part of a robust market and helps ensure companies are priced appropriately.

How are my shares protected while they’re being loaned out to another investor?
If the party borrowing the shares defaults on the deal and can’t return them, then the trading platform pays out from cash, shares or bonds put up as collateral by the borrower. US regulations require anyone borrowing shares to put up assets of at least the same value as collateral.

Typically, the party borrowing the shares must put up collateral in case they cannot return the shares. Collateral will usually be cash although bonds can also be used. It’s worth checking out what collateral is required from borrowers, how much they have to put up (it should be equivalent to at least 100% of the value of the borrowed shares) and how often the amount of collateral is adjusted to take account of movements in the value of the borrowed shares (frequently is better).

Whoever is using the shares is the one doing the risky trade such as short selling– not you.

Can any type of shares be lent out like this?
In theory yes, but it’s currently only being offered in New Zealand to retail investors for shares listed on US exchanges. However, some managed funds may have the option to participate in stock lending.  This should be disclosed to you including how it works and who gets what share of the revenue generated. 

What should I know before allowing my shares to be lent out to other investors?
This is a new revenue stream for the investing platform owners – they are using your shares to earn fees from someone else. While it does the work finding a borrower, remember it’s your property they’re using. And the platform that’s lending out your shares is taking most of the revenue.

Consider if you’re getting a good deal and it’s properly explained what you stand to gain.

Importantly, are you comfortable the promises and commitments being made by the investment platform around its ability to pay you should the other party default and can’t return your shares?

The platform that you’ve bought your shares through will be using a lending agent to lend out your shares, so check out its credentials too. You could check - for example - that the lending agent being used will receive the collateral before your shares are lent out.

And while you might activate a share borrowing option, it doesn’t necessarily mean there will be anyone interested in your shares. Any income stream from allowing it is likely to be unpredictable.

“While you might earn some money from having your shares available for lending out, your main focus should still be appropriate returns after fees from a well-diversified investment portfolio.” Paul Gregory.

 

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