Understanding stock (or securities) lending

Stock lending occurs when a brokerage borrows securities from one investor to lend them to another. The borrower could end up being an individual or another financial institution. The transaction is governed by a regulated framework and follows terms outlined in a securities lending agreement. To incentivize lending, investors receive income from the borrower, just as one would when they rent out anything.

In many ways, lending a stock is the same as lending anything else. You lend out shares you hold to someone else in exchange for a fee, which can vary by institution. It can be common for the borrower to sell the shares in the hope that the price will fall, so they can buy the shares back at a cheaper price before returning the borrowed stock.

Many brokerages make it possible for regular investors to participate in securities lending. In most cases, lending programs are passive for clients – you enroll in the program and your brokerage will look for borrowers that match your holdings. If a loan is issued, you'll earn fees. There's nothing more for you to do. 

Here are the five main steps that happen in the background as part of a securities lending program:

Step 1: A securities lending agreement is created: This is a formal contract between the security lender and borrower that outlines the terms of the loan, including the length, fees and collateral requirements. Once enrolled in the program, TD the brokerage takes care of the rest by looking for borrowers. Although there is no guarantee that shares will be loaned out, the lender will earn fees on any securities that are. 

Step 2: TD The brokerage collects collateral from the borrower: The borrower provides collateral, such as cash, securities or a letter of credit, to the brokerage in order to secure the loan.  

Step 3: Securities are transferred: TD The brokerage transfers the securities to the borrower but the lender retains beneficial ownership. A lender can sell the shares themselves at any time, and can recall the shares to participate in a proxy vote although this process may not be instantaneous.   

Step 4: Fees are paid: The lender collects fees from the  borrower for the duration of the loan.  

Step 5: Securities are returned: At the end of the loan, the borrower returns the stocks to the lender, and the collateral is released.

When you loan your securities, you are temporarily giving up ownership of those shares. While your shares are on loan you also give up your proxy voting rights, but you will still receive distributions or dividends from those securities. Because you don’t own the stock directly, the distribution or dividend will be paid out through a “manufactured payment” from the brokerage that mirrors the actual distribution or dividend.

While borrowers can use the shares however they please, they have to provide collateral to protect the lender in the unlikely case the loan isn't paid back.

The key participants in a security-lending transaction include:

• Lender: Typically, an investor or institution
• Borrower: This could be a financial institution or hedge fund
• Broker: Facilitates the process by overseeing the lending agreement and paying interest to lenders

There are different types of securities lending, including fully paid and partially paid lending. However, this article will focus on fully paid lending.

Fully paid lending simply means that you have not used margin (borrowed money) to buy your shares so you have "fully paid for them" and  you own them outright. Investors can enroll in Fully Paid Lending to allow a broker to lend out their securities, in turn, earn passive income generated by the fees paid by the borrower. If the investor doesn't choose to enroll, the broker can't lend out the shares. TD is in the process of making fully paid lending available to Direct Investing clients soon.

Stock-based lending benefits investors on both sides of the transaction while also supporting the efficiency and liquidity of capital markets. 

Securities lending offers investors a way to generate passive income from their stocks without having to sell them. 

Securities lending can offer several advantages for lenders:

• Additional income: Lenders can earn a fee for lending out stocks 
• Potential price appreciation: Borrowers have to return the stock at the current price, meaning lenders don’t give up any potential gains they have while their shares are on loan
• Retain ownership: Lenders retain ownership of their stocks and can sell them at any time.  However, they give up voting rights while the securities are on loan. 
• Avoid taxable events: Lenders don’t have to sell their securities to generate income (while those payments may still be subject to tax, stock lending could help avoid a larger taxable event when selling shares from a non-registered account)

Like all investing, lending securities comes with some risk. As with lending a power drill to your neighbour, there’s the chance the borrower won’t return the item. To limit this risk, brokerages require borrowers to have enough collateral to cover 100% of borrowed shares. Here are a few of the other risks to be mindful of:

There's a small risk that the value of the shares borrowed could grow such that the borrower is unable to return the shares. To mitigate this credit risk and ensure lenders are 100% covered, borrowers are required to provide collateral equal to the value of the shares.

The collateral will also protect the lender if the borrower doesn’t have the funds to repurchase the shares following a short sale, which involves selling the borrowed securities with the intention of buying them back at a lower price.

If you’ve ever loaned a tool to a neighbour you know that while you may still own the item, as long as it’s in their possession you are not able to use it. The same applies to loaned stock. As long as the borrowed holds the shares, you will not be able to execute your voting rights. If you want to vote on your securities, you will need to recall the shares, which ends the loan.

The Canadian Investment Regulatory Organization (CIRO) is proposing revisions to securities lending rules. After a comment period in early 2024, CIRO is working on proposed amendments to enhance regulation around retail fully paid securities lending programs, clarify the requirements and allow different lending models and client types. The final rules are expected in the spring of 2025. In the meantime, here are some key regulations and compliance requirements:

Regulations governing fully paid lending are overseen by CIRO in Canada to ensure transparent and protected participation among parties. They include:

• Client consent: A broker can only borrow a client's fully paid securities with their consent, usually through a signed securities loan agreement.
• Disclosure of risks: Brokers must clearly disclose all aspects of the lending program to clients, including potential risks, fees and how their securities will be handled. 
• Collateral requirements: Brokers are required to hold sufficient collateral equal to the value of the loaned securities. 
• Clear recordkeeping: Detailed records must be maintained to clearly differentiate between client securities that are on loan and those held in the regular account, including the amount of collateral received. 
• No asset reuse: Brokers cannot use the loaned securities for their own trading activities, preventing potential conflicts of interest. 
• Reporting obligations: Brokers must comply with regulatory reporting requirements regarding fully paid lending activities, including details about loaned securities and collateral held.

Beyond the compliance requirements, there are a few other things to take into consideration:

• Market volatility: The value of collateral held may fluctuate based on market conditions, impacting the associated risk for lenders, which is why the collateral is updated daily.
• Education: Brokers have a responsibility to educate clients about the risks and benefits of fully paid lending before they participate in such programs

Securities lending has a key role to play in capital markets, helping to increase liquidity while providing funding and income for all parties involved. Like all investments, there are pros and cons to the strategy. Investors considering lending their securities through this type of arrangement should be informed about the opportunities and risks.