A Quick Guide to Understanding Securities Lending
What happens on Wall Street is mysterious to many people.
Words like arbitrage and hedging get thrown around, but no one explains what they mean. There is one phrase everyone should understand because many retirement funds use it.
If it’s not familiar, keep reading and we’ll cover the basics.
What Is Securities Lending?
This kind of lending takes one of two forms.
In the more common form, a company or person who controls shares of stock lets a second party borrow those stocks. The borrower offers different shares in a different stock as collateral for the lender.
The borrowing is typically short-term and the borrower pays a fee when returning the borrowed shares.
Think of it like this.
Johnny needs a pickup truck for the day, so he borrows Larry’s pickup truck. In exchange, Larry gets Johnny’s sedan for the day. When Johnny returns the pickup, he gives Larry $50 for the hassle.
The less common form resembles a bank loan.
A person with shares of a stock transfers it to the lender. The lender gives the person a cash loan. When the person pays off the loan, the lender returns the stock.
What’s It Used For?
Securities lending has several uses.
Shorting stock is one of the more common uses.
That’s where someone bets a stock price is too high. They borrow shares and sell them at the current price, betting the stock price will drop. They plan on buying the shares back at the lower price and pocketing the difference.
Another common use is hedging, which happens when a broker or hedge fund acquires shares of several stocks to minimize risk.
Say the hedge fund expects big growth in the dangling widget market. Rumors say that WidgCo has a game changer product ready for launch. The hedge fund goes long on WidgCo and shorts Dangle Inc.
If stock prices rise for both companies, the hedge fund bets that the profit from WidgCo will exceed the loss from Dangle Inc.
In some cases, banks agree that they can buy or sell some kinds of securities at any time. They will borrow securities as a way to meet those obligations.
Here’s a more real-world example of hedging.
You’re trying out a new recipe tonight, so you pick up some groceries at the store. You also buy a frozen pizza at the store. If the recipe is bad, you can eat the pizza instead.
What Are the Risks?
There are a few risks involved in securities lending.
Someone bets wrong when shorting stock and the price rises. The bad scenario is that the borrower defaults. The good news is that collateral stock value covers buying your shares back.
The really bad scenario is two-part. First, the borrower loses their shirt. Second, the collateral stock value can’t cover buying back the borrowed shares.
Securities lending sounds like something complicated.
At its core, it’s just a trade of stock shares for collateral. Sometimes the collateral is another stock and sometimes it’s hard cash.
There are some risks when a borrower shorts a stock, but the borrower takes on most of the risk.
StockLoan Solutions specializes in stock lending. We help you convert stock into liquid capital without selling off your shares. For more information, contact us today.