Why you need to be taking advantage of this if you own stocks.
Today I want to discuss with you guys the concept of securities lending, also known as stock lending, as a way to make additional returns on your investment. Now this is not financial advice, just facts. This is to educate you and provide you with information in order for you to make your own decision on whether or not this is right for you.
Lending while earning interest is not a new concept by any means. It has probably been around since the invention of currency itself. Financial institutions lend out loans all time, so why not us. It is time for us to reap the benefits from the system.
I am going to show you a way to make additional returns anywhere from 2–10% yearly on some of the stocks you are currently holding. By doing almost nothing. You just need to set it and forget it.
So what is securities lending?
It is exactly like what it sounds, you lend out your securities or in most cases, the stocks that you currently own and you will be paid interest in return. Your stock can be used for activities such as short selling, hedging, and other strategies. How much interest you earn on your stock will all be determined by supply and demand. The more demand there is for a stock, the more interests you will be earning.
So how does it work?
Here is an example of someone borrowing your stocks for short selling. As this is likely the most common scenario. Let’s say Debbie here wants to short stock “A” because she thinks it will drop to a lower price. Now, Debbie doesn’t want to front the money for the stock. She wants to borrow the stock from you to short the stock. You as a savvy retail investor have done your due diligence and believe stock “A” will continue to rise for the foreseeable future. That is why you own it. What Debbie does is, she borrows stock “A” from you with interest to sell immediately. Debbie hopes to make a profit by selling the borrowed stock at $100 now and buying it back at a lower price, say $70. If she is right, she makes a profit of $30 per share for herself minus the interest owed for borrowing the stock. If she is wrong, she loses money because she has to buy the stock back at a higher price, plus the interest owed from borrowing the stock.
That in general is what it means to short a stock. Short seller generates a profit on the difference of the price when the stock falls. They lose money if the stock goes up.
You may be asking whoa hold on, who is Debbie and how do I know I can trust her. Well your brokerage holding your stock is thinking the very same thing. Per regulations, Debbie must put up collateral for the borrowed stock. At minimum, she must put up 102 percent of the market value plus debt securities, and any accrued interest.
This collateral is put into a bank to be held and be paid to you should Debbie default on the loan and is unable to return your shares.
Regardless, if Debbie is right or wrong on her bet, you and your brokerage will make money from the interest. That is right, your brokerage wants a cut of that interest since they are doing all the paperwork moving the stock around and securing the collateral. How much they take depends on your brokerage. Most will take a 50% cut.
So we know the benefit of lending out your stock. You get money from your shares based on the interest rate. If for some reason the borrower, Debbie, defaults on the loan, the collateral will be used to buy back your shares and deposited in your account.
So what are the cons to lending out your stocks?
Well don’t expect to make much money or any off of growth and stable stocks such as Apple, Microsoft, ETF that tracks the indexes, etc. Not a lot of people are shorting those stocks. This goes back to the supply and demand mentioned earlier in determining the interest rate for lending. You may never lend out any of these stocks for shorting. Because who in their right mind will short them?
Another con is you lose your rights on the stock, kind of. When you lend out your shares, all rights are also transferred to the borrower. Now you can request the stocks back prior to proxy voting or dividends payment. However, do note that the borrower usually sends payment, called “cash-in-lieu”, equal to the amount of the dividends that you may have missed out on, back to you. The only catch is that payment will be taxed as regular earned income instead of capital gain tax. Now this may or may not matter to you depending on various factors. Consult a tax professional.
Another con is you may not get to pick and choose which stocks in your portfolio you want to lend out. Some brokerage will ask you if there are any stocks that are off limits for lending such as company stocks, etc. Now this may not be important to most, but if you own a particular stock because you are hoping for a short squeeze, then this could be very important. Because you are essentially lending your shares to cover those shorts. The opposite of what you are trying to do. However, chances are you won’t have enough shares that it will matter for a short squeeze. If you do own enough shares where they can make a difference.. Well shoot, kudos to you, you ape!
What are the risks?
Well the shares on loan are not covered under the Securities Investor Protection Corporation (SIPC). So you do run the risk of the borrower defaulting on a loan and not being able to pay you back. However, reputable brokerage will provide collateral to cover this in the event it happens. The biggest risk however is if your brokerage goes belly up as well. Highly unlikely if you are using a reputable brokerage to buy and sell your stocks.
In conclusion, securities lending is a great idea for most investors. Especially those that are long term investors. It provides additional income on stocks you already own. If your mentally is having your money work for you, why not have your stocks work for you as well?