Lesson 7: Securities Lending and Borrowing

What is Securities Lending?

Securities lending is the practice where investors (typically large institutions or ETFs) lend their shares to other investors for a fee.

The Players:

• Lenders: Large institutional investors, mutual funds, ETFs
• Borrowers: Typically hedge funds, institutional investors
• Agent: Usually a large bank that facilitates the transaction

Why Would Anyone Lend Their Securities?

Generate Extra Income
Lenders receive fees for lending their shares, which can enhance portfolio returns.

Example: A pension fund holding millions of shares of Apple can earn additional income by lending those shares while still maintaining long-term ownership.

Why Borrow Securities?

The primary reason to borrow shares is for short selling.

What is Short Selling?
Short selling is a strategy where investors profit from a stock’s price decline.

How Short Selling Works:

1. Borrow shares from a lender
2. Immediately sell them at the current market price
3. Wait for the price to fall
4. Buy back the shares at the lower price
5. Return the shares to the lender
6. Keep the difference as profit (minus borrowing fees)

The Short Selling Process Step-by-Step

1. Identify Overvalued Stock: A hedge fund believes Company XYZ is overvalued at $100 per share
2. Borrow Shares: Borrows 1,000 shares from a pension fund through a prime broker
3. Sell Shares: Sells the 1,000 shares for $100,000
4. Price Declines: Stock falls to $70 per share as predicted
5. Buy Back: Purchases 1,000 shares for $70,000
6. Return Shares: Returns shares to the lender
7. Profit: Keeps $30,000 profit (minus borrowing fees and commissions)

Risks and Considerations

For Lenders:

• Counterparty Risk: The borrower might default
• Collateral: Lenders require borrowers to post collateral (usually cash or other securities)
• Voting Rights: Typically, lenders lose voting rights while shares are loaned

For Borrowers (Short Sellers):

• Unlimited Loss Potential: If the stock price rises instead of falls, losses can be unlimited
• Borrowing Costs: Ongoing fees to borrow the shares
• Short Squeeze: If many short sellers try to cover positions simultaneously, it can drive prices up rapidly

Impact on the Market

Benefits:

• Provides Liquidity: Adds trading volume to markets
• Price Discovery: Short sellers can help identify overvalued stocks
• Income Generation: Allows long-term holders to earn extra returns

Controversies:

• Market Manipulation: Concerns about coordinated short attacks
• Systemic Risk: Large short positions can exacerbate market declines
• Ethical Debates: Some view short selling as betting against companies

Real-World Example: GameStop Short Squeeze (2021)

In 2021, GameStop stock became the center of a massive short squeeze:

• Many hedge funds had large short positions
• Retail investors coordinated buying through social media
• Stock price skyrocketed, forcing short sellers to buy back at huge losses
• Illustrated the risks of heavy short selling

Practical Exercise

Research a company that currently has high short interest (percentage of shares being shorted). Consider why investors might be betting against this company and what risks the short sellers are taking.