Securities lending: how funds and brokers lend out shares to short sellers

An investor who owns shares does not need them every day. The shares can sit idle, or they can be lent—for a fee—to other investors who need them temporarily, typically to facilitate short selling. Securities lending is the institutional practice that monetises this otherwise-idle ownership, and it produces meaningful incremental income for the funds and accounts that engage in it.

What securities lending is

Securities lending is the temporary transfer of securities from one party (the lender—typically a fund, pension scheme, or large brokerage account) to another party (the borrower—typically a hedge fund or trading desk) in exchange for collateral and a lending fee. The lender retains the economic ownership of the securities (they receive any dividends or other distributions) and has the right to recall the loan; the borrower acquires the temporary right to sell or otherwise use the securities.

The standard structure is a securities-lending agreement that defines the loan duration, the collateral arrangement (typically cash or government securities at 102–105% of the loan value, marked-to-market daily), and the fee. The fee is typically expressed as an annualised rate on the value of the loaned securities, and varies enormously by security: easy-to-borrow large-cap stocks lend at fees of a few basis points per year; hard-to-borrow names with high short interest can lend at fees of 10–50% annualised or more.

The market is large. Global securities-lending revenue exceeds USD 10 billion annually, with the bulk concentrated in equity lending. The lenders are dominated by large institutional holders—index funds, pension schemes, central banks, sovereign wealth funds—who hold large diversified positions for extended periods and can therefore lend without disrupting their investment strategies.

How it works

The lending process is intermediated by securities-lending agents—typically large custodian banks (State Street, BNY Mellon, JPMorgan) that manage the loan book on behalf of beneficial owners. The agent identifies borrower demand, negotiates the loan terms, manages the collateral, and credits the lender with the lending fee net of any agent fee.

For the borrower, the loan provides the securities needed to complete a short sale or to deliver against a settlement obligation. The borrower posts collateral with the lending agent, pays the lending fee, and is contractually obligated to return the securities when the loan is recalled or terminated. If the borrower defaults, the lending agent uses the collateral to repurchase the securities in the market.

For the lender, the economic effect is to earn the lending fee on top of the underlying investment returns. The fee is meaningful for hard-to-borrow securities but typically small for easy-to-borrow ones. ETFs holding diversified equity portfolios typically generate 2–10 basis points per year of additional return through securities lending—a meaningful contribution given that ETF expense ratios are often in the 5–20 basis point range.

What the evidence shows

Securities-lending revenue is materially higher for funds with concentrated holdings in less-liquid or hard-to-borrow names. A small-cap equity ETF can generate 30–80 basis points per year from lending, more than offsetting the fund's expense ratio. A large-cap ETF holding only the most-liquid names typically generates less than 5 basis points.

The revenue distribution between the fund and the fund's investors depends on the fund sponsor's policies. iShares, State Street SPDR, and Vanguard all lend securities held in their ETFs and pass through the bulk of the lending revenue to the funds (and therefore to fund investors); some smaller sponsors retain a larger share of the lending revenue as fund-level income. The disclosed lending policy varies by sponsor and should be checked when comparing similar ETFs.

The risks of securities lending are concentrated in collateral management and counterparty risk. The 2008 financial crisis exposed cases where lending programs had reinvested cash collateral into longer-duration or less-liquid instruments, producing losses when the lending agreements were terminated and the collateral could not be returned at face value. The major lending agents have since tightened collateral-investment policies, but the structural risk remains.

Limitations and trade-offs

Securities lending introduces counterparty risk that the underlying buy-and-hold position would not have. The borrower's default risk is mitigated by the collateral, but a sudden market dislocation can produce situations where the collateral is insufficient to repurchase the lent securities. The major custodian banks indemnify their lending clients against borrower default in many cases, providing a layer of protection that smaller lending programs do not offer.

For ETFs and funds engaging in lending, voting rights are temporarily transferred to the borrower for the duration of the loan. A fund that lends out a position cannot vote those shares at the company's annual meeting; the borrower (typically the short seller, who has economic interest opposite to the fund) holds the voting rights. Funds with active corporate governance programs typically recall lent shares before key vote dates to retain voting capability.

The practice has been criticised in some quarters as enabling short selling that contributes to share-price declines. The empirical evidence is that securities lending and the short selling it facilitates contribute to price discovery and market efficiency rather than systematically depressing prices, but the perception persists in some retail and institutional investor populations.

Securities lending in pfolio

Securities lending is performed at the broker and fund level, not in pfolio. ETFs that engage in securities lending may pass some or all of the resulting income to shareholders, raising the fund's effective return relative to its TER; this is reflected in the fund's total return as reported in pfolio's price series.

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