The rise of fully paid securities lending opens new opportunities for brokers and retail investors

Key Takeaways

• FPSL has gained traction among brokers to earn additional income
• Retail investors sitting on huge untapped resources
• Multiple benefits and challenges to FPSL

Retail investors usually earn returns through dividends and capital appreciation when securities are sold. However, there is another option to make a quick buck in the short term: a fully paid securities lending program (FPSL), which for years was an option only for big financial institutions.

Investors can make money by permitting brokers to lend securities they fully own and which are sitting idle.

FPSL has been around for a while and has gained fresh impetus after brokerages like Robinhood, Fidelity, TD Ameritrade, Ally, and Charles Schwab, among others, started promoting it. Brokers are using the strategy to boost income, and it is spreading, with Robinhood launching the service for UK retail customers in early September.

According to Finadium, it is the start of a ‘generational change’ in the market, and more technology-first brokers are joining the action. The head of the Options Clearing Corp (OCC), Obie Knapp, calls it a ‘new democratization of securities lending’.

The surge in recent years in retail investment across asset classes and in passive investment strategies like exchange-traded funds (ETFs), using low- or zero-free online platforms, points to huge untapped potential for FPSL, which is largely based on stocks.

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How fully paid securities lending works

FPSL is an option for earning passive income. Once an investor agrees to participate in an FPSL program, the broker lends the securities to other financial institutions and market participants, such as fund houses, banks and proprietary trading firms. These market participants borrow the securities usually to facilitate short sales but also to settle trades or support more sophisticated trading strategies. The borrowers pay brokers a fee, and brokers share a fraction of that fee with customers.

The investment strategy is demand-driven and comes into play in case of a securities shortage. Brokers are likely to approach investors only when they have exhausted their supply of securities to lend and need to continue trading activities.

Easily available securities, like most stocks in the S&P 500, usually offer lower returns for lenders as they are not often shorted. In contrast, securities that are harder to borrow tend to be more lucrative for lenders. For example, Robinhood said that in 2018 Tesla shares demanded a higher loan fee than Google or Microsoft shares. A high number of investors shorting Tesla increased the demand for borrowing Tesla shares to meet delivery requirements and support short-selling activities.

Earnings from FPSL depend on factors like borrowing demand, the overall lendable supply of the security, short-selling and hedging interest, and market conditions, Fidelity notes.

The benefits of fully paid securities lending

Though brokers are typically the biggest gainers in FPSL, investors can also earn from it. Here are some key advantages to note:

• Lenders gain interest commission for loaning out their securities
• Lenders receive collateral for the duration of the loan period
• Customers continue to own securities, even though they’re loaned
• Customers can sell securities at any time, even while they’re out on loan
• Customers can choose to sell the securities even during the lending period. In that case, they lose the earnings from the FPSL program

The challenges of fully paid securities lending

Despite all the advantages, FPSL programs have their shortcomings. Here’s what needs to be considered when signing up for FPSL:

• Investors can’t be choosy as it is completely up to the broker to decide which securities to lend from the portfolio
• Investors also lose some shareholder rights, such as voting, while their shares are out on loan
• Investors need to be aware of some tax considerations. For instance, if they own dividend-paying stock, they will receive cash instead of the regular dividend payment, which typically means a higher tax rate.
• Investors lose SIPC insurance for the securities out on loan. That means that if their broker goes out of business, SIPC will not cover the value of those lost securities. However, to make up for the loss of SIPC insurance, brokers generally hold collateral (usually cash) at least equal to the value of the loaned securities. This collateral is held at a third-party financial institution to hedge the risk of default, ally notes.
• Investors should be aware that there’s no guarantee that someone will borrow their securities. And, if they do, there is no assurance about which securities will be borrowed, for how long, or in what volume. This uncertainty can significantly impact the earning model for a securities lending strategy.

Democratization of financial markets

Whilst only accounting for a relatively small part of the market, retail investors have begun to utilize securities lending for incremental income via a range of trading platforms and aggregators (firms that combine small retail holdings into tradeable volumes).

It forms part of the democratization of financial markets and supports the increase of retail participation in capital markets – the emergence of low-cost retail investment products (e.g., tracker funds such as ETFs) is in part due to management costs being supported by revenue gained from securities lending.

By making investing in the financial markets more appealing at a lower cost, securities lending stimulates retail investment flowing into the capital markets. And it also helps mobilize more assets, ensuring that investors can access the collateral they need to support their activities, whether it’s for trading, hedging, or meeting regulatory requirements.

For providers of FPLS, it’s imperative that they have a strong and scalable technological infrastructure in place, with an API framework that allows for seamless interaction with external trading platforms, a system that can process mass volumes of data in real-time and robust security protocols. Teaming up with proven, global vendors is often the most cost-effective route to securing such a technological set-up.