How securities borrowing and lending works

Investors who lend their securities receive a fee from the borrower that can vary based on a number of factors. Supply and demand play a major role in determining fees. For instance, high short interest in a company’s shares or limited availability can drive prices higher. Other factors that impact fees include the length of the loan and the risk that the shares could be recalled.

The more widely available stocks, known as ‘general collateral,’ usually produce lower returns from securities lending, of up to 0.5% (50 bps). In-demand stocks, known as ‘specials,’ can command much higher returns varying from 1.0% (100 bps) to over 100% (10,000 bps) annually in more extreme cases, such as in corporate action scenarios or in a ‘short squeeze.’

In addition to fees, lenders also receive collateral, such as cash, government bonds and corporate bonds, exceeding the value of the loaned assets. This overcollateralisation is meant to protect the lender if the borrower defaults, the value of the borrowed securities increases or the value of the collateral decreases.

The first formal equity lending transactions took place in the City of London in the early 1960s, but SBL only really took off as an industry in the early 1980s. Today, in addition to improving liquidity and price discovery, SBL contributes to the stability of financial markets, by reducing settlement fails, where a party in a trade fails to deliver securities by the agreed date.

In theory, anyone who owns a security can lend it, and while SBL was traditionally reserved for large institutions, Optiver has invested in platforms like Sharegain that make it accessible to individual investors. For instance, Sharegain partners with investment platforms and online retail brokers to allow their retail clients to lend out securities and generate additional income.

Here’s a typical lending scenario involving a mutual fund, its custodian bank, a market maker and shares of Apple Inc. (AAPL).

• The mutual fund, which holds AAPL shares long-term, agrees to lend 200,000 shares through its custodian
• The market maker, via its prime broker, requests to borrow the shares to fulfill market demand or manage its inventory
• The custodian transfers 200,000 AAPL shares to the market maker.
• In return, the market maker posts cash collateral (e.g., $40.8 million if AAPL trades at $200, plus a 2% margin).
• The market maker sells the shares to make a two-sided market or execute a direct-counterparty sell order.
• While the loan is open:
  • The market maker pays a borrow fee (e.g., 0.25% annualized) to the custodian, which is then passed on to the mutual fund.
  • While the market maker receives the actual dividend, it is contractually required to pay it to the mutual fund, which retains economic exposure to AAPL.
  • Voting rights pass to the market maker for the duration of the loan.
• At loan termination (could be overnight or open-ended):
  • The market maker returns 200,000 AAPL shares.
  • The cash collateral is returned, net of fees.

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