Borrowing stock

What Is Borrowing Stock?

Borrowing stock, also known as securities lending, is the temporary transfer of a security from one party, the lender, to another, the borrower. This transaction is a core component of securities lending, a significant activity within capital markets that facilitates various investment strategies and market operations. In exchange for the borrowed stock, the borrower provides collateral, typically in the form of cash or other securities, and often pays a lending fee or interest rate to the lender. The agreement obligates the borrower to return equivalent shares to the lender either on demand or at the end of an agreed term.

History and Origin

The practice of borrowing stock has roots extending back to the earliest days of equity trading. While informal arrangements likely existed earlier, the formalization of securities lending began to gain prominence in the early to mid-20th century. Notably, the New York Stock Exchange (NYSE) once operated a "loan post" dedicated to facilitating such transactions, though this ceased in 1933 amidst public scrutiny over short selling. The modern form of equity lending became highly prevalent as an industry in the early 1980s, evolving from a back-office function to a sophisticated financial service. This growth was significantly spurred by custodian banks recognizing their potential to act as agent intermediaries, mobilizing large pools of securities from their clients, such as pension funds and institutional investors, for lending. This development helped increase the overall scale and sophistication of the market.⁸ According to the Association of Corporate Treasurers, the history of securities lending is "inextricably linked with the custodian banks" due to their role in aggregating and marketing the service to their customers.⁷

Key Takeaways

Borrowing stock involves the temporary transfer of securities from a lender to a borrower, typically for a fee and against collateral.
It is a fundamental activity in securities lending, enabling various market strategies.
Borrowers provide collateral to protect the lender against potential default or changes in the value of the borrowed stock.
Lenders receive fees or interest for lending out their shares, generating additional income from otherwise idle assets.
The practice contributes to market liquidity and market efficiency.

Interpreting Borrowing Stock

Borrowing stock is not an end in itself but rather a mechanism that enables various financial activities and strategies within the capital markets. For a broker-dealer or an institutional investor, the ability to borrow stock is crucial for facilitating trades and managing positions. Its primary interpretation lies in its utility: it provides the necessary shares for transactions where the seller does not own the security at the time of sale. This could be for hedging purposes, to facilitate arbitrage strategies, or most commonly, for short selling. The availability of borrowed stock can also indicate the market's sentiment towards a particular security; a high demand to borrow a stock might suggest a significant number of investors are anticipating a price decline.

Hypothetical Example

Consider Jane, an investor who believes that shares of "Tech Innovations Inc." (TII) are overvalued and expects their price to fall. To profit from this anticipated decline, Jane decides to short sell TII shares.

Jane opens a margin account with her broker-dealer.
She instructs her broker to short sell 100 shares of TII, which are currently trading at $50 per share.
Since Jane does not own TII shares, her broker must locate and borrow 100 shares on her behalf. The broker identifies a lender (e.g., a pension fund or another institutional investor) willing to lend the shares.
The lender transfers the 100 TII shares to Jane's broker. In return, Jane's broker provides collateral (e.g., cash equal to 102% of the value of the TII shares, or $5,100) to the lender. Jane also agrees to pay a small lending fee to the lender.
Jane's broker then sells the borrowed 100 TII shares in the open market, generating $5,000 in proceeds (minus commissions). This cash is held in Jane's account.
A few weeks later, as Jane predicted, TII's share price falls to $40 per share. Jane decides to close her short position.
She buys 100 TII shares from the open market for $4,000.
These purchased shares are then returned to the original lender, fulfilling Jane's borrowing obligation.
Jane profits $1,000 (excluding fees and commissions) from the transaction, which is the difference between the selling price and the buying price.

Practical Applications

Borrowing stock is integral to the functioning of modern financial markets, underpinning several key activities:

Short Selling: This is the most common use of borrowed stock. Investors borrow shares, sell them, and hope to buy them back later at a lower price to return to the lender, profiting from the decline.
Arbitrage Strategies: Borrowing stock enables arbitrageurs to exploit price discrepancies between different markets or related securities, such as convertible bonds and their underlying stocks.
Settlement and Delivery: Broker-dealers may borrow stock to cover "failed" deliveries, ensuring that transactions settle on time even if there are temporary shortages of shares.
Hedging: Borrowed stock can be used to construct complex hedging strategies, offsetting potential losses in other investment positions.
Market Making: Market makers use borrowed stock to provide liquidity, ensuring that buyers and sellers can always find a counterparty for their trades.

Regulatory bodies closely monitor stock borrowing and short selling. For example, the U.S. Securities and Exchange Commission (SEC) introduced Regulation SHO, which includes requirements for brokers to locate securities before a short sale can be executed and imposes delivery requirements.⁶,⁵ Additionally, the FINRA (Financial Industry Regulatory Authority) requires member firms to report short interest positions in all equity securities twice a month, providing transparency into the overall short selling activity in the market.⁴,³

Limitations and Criticisms

While borrowing stock facilitates essential market functions, it is not without limitations and criticisms. For lenders, the primary risks associated with securities lending include counterparty risk—the risk that the borrower may default and be unable to return the securities. To mitigate this, lenders typically require collateral that is equal to or greater than the value of the loaned securities. However, there is still collateral risk, meaning the value of the collateral itself could fall below the replacement cost of the borrowed shares, especially in volatile markets.

²For borrowers, particularly those engaging in short selling, the risks are substantial. These include:

Unlimited Loss Potential: If the price of the borrowed stock rises indefinitely, the borrower's losses are theoretically unlimited, as they must eventually buy back the shares to return them.
Margin Calls: Borrowers must maintain a certain level of collateral in their margin account. If the stock price increases significantly, they may face a margin call, requiring them to deposit additional funds or securities, or have their position forcibly closed by the broker-dealer.
Lending Recalls: The lender can recall the borrowed shares at any time, forcing the borrower to cover their position, potentially at an unfavorable price.
Dividends and Fees: Borrowers are responsible for paying any dividends or other distributions made on the borrowed stock to the lender, in addition to the lending fee.

Critics also contend that aggressive short selling, enabled by borrowing stock, can sometimes exacerbate market downturns or lead to manipulative "bear raids" on companies. Conversely, proponents argue that borrowing stock for short selling contributes to more accurate price discovery and discourages corporate malfeasance by providing a mechanism for investors to express negative views on overvalued or poorly managed companies.

Borrowing Stock vs. Short Selling

The terms "borrowing stock" and "short selling" are often used interchangeably, but they represent distinct, though closely related, concepts.

Borrowing stock refers to the act of acquiring shares from a lender with the agreement to return an equivalent number of shares at a later date, typically against collateral and a fee. It is a fundamental transaction in the securities lending market. The primary motivation for borrowing stock is to gain temporary control of a security that one does not own.

Short selling, on the other hand, is an investment strategy. It involves selling securities that an investor does not own, anticipating that their price will fall. To execute a short sale, an investor must first borrow the stock. Therefore, borrowing stock is a prerequisite and a crucial enabling mechanism for short selling, but it is not the strategy itself. An investor might borrow stock for reasons other than short selling, such as to facilitate a "failed" trade delivery or to engage in certain arbitrage strategies that do not involve a directional bet on the stock's price decline.

In essence, borrowing stock is the how, while short selling is one of the whys.

FAQs

Why do investors borrow stock?

Investors borrow stock for several reasons, primarily to engage in short selling, where they profit from a stock's price decline. They also borrow stock for arbitrage opportunities, to facilitate trade settlement, or to create complex hedging strategies against other investments.

Who lends out stock?

Typically, large institutional investors such as pension funds, mutual funds, insurance companies, and exchange-traded funds (ETFs) lend out their stock. They do this through their custodian banks or prime brokers to earn additional income (lending fees) on their portfolios.

What is collateral in stock borrowing?

Collateral is an asset, usually cash or highly liquid securities, that the borrower provides to the lender when borrowing stock. This collateral protects the lender in case the borrower fails to return the borrowed shares or if the value of the shares changes significantly.

Are there risks for the lender when stock is borrowed?

Yes, lenders face risks such as counterparty risk, where the borrower might default. While collateral mitigates this, the value of the collateral itself can fluctuate. Lenders also face risks related to reinvesting cash collateral, if that's the form of collateral used. The International Securities Lending Association (ISLA) details several risks for lenders, including operational and market risks.

¹### Does borrowing stock affect the company whose shares are borrowed?
Directly, borrowing stock does not affect the company. The shares are transferred between investors, not issued or retired by the company. However, the associated short selling activity, if significant, can lead to increased selling pressure on the stock, which may impact its market price.