Securities lending is the transfer of stocks or derivatives from one party to another most commonly for the purpose of facilitating the settlement of a trade or delivery of a short sale. As with any loan, the borrower must put up collateral in cash, securities or credit, and he must pay a fee that is often determined as a percentage of the value of the loaned securities.
When an individual investor wishes to short sell a stock, or sell a stock in anticipation of its value going down, then buy it again later at a lower price, in some cases he is required to borrow the stock from another individual or institution with a lending contract as described. Otherwise, an individual might borrow stock in order to cover a short position, or complete the delivery of the stock in a naked short sale, when possession of the security is not necessary to initiate the trade.
Securities lending is necessary for regular short selling, or short selling where shares are first borrowed and then returned by the borrower at a later date. In addition, borrowing securities in order to cover a position or at a different price from the initial trade can act as a hedge or continue the short position for a longer period of time if it is prematurely called back by the initial lender. This hedging technique can even be more cost-effective than the use of call options.
For an investor get the best rates when borrowing securities, it is wise to use cash as collateral rather than credit. When the lending institution receives cash as collateral, it can be invested and create returns. When this occurs, the borrower pays a lower, rebated rate since the lender was able to create part of the fee with the collateral. This is not possible with a line of credit, so the borrowing rate would effectively be higher.
Short selling is an excellent way for investors to hedge risk or make money in a bad market. For investors planning to sell securities short, it is important to have a good understanding of securities lending.