CHRIS HUGHES, Shareholder Analyst

The borrowing and lending of shares dates back to the earliest days of stock trading. Put simply, it involves the owner of shares ‘lending’ them to another investor or institution who ‘borrows’ them for a given length of time. Borrowing and lending deals are often transacted by market makers or dealers, although institutional investors can carry out stock lending. The borrower must offer collateral, usually equal to at least the value of the shares being borrowed and pay a ‘borrow fee’ along with interest. In exchange, they receive the shares, including a transfer of ownership of the shares for an agreed length of time. Stock borrowers and lenders usually use “collateral accounts” for these transactions.

WHY BORROW OR LEND SHARES?

Lending shares provide benefits to the Lender in a number of ways. When a broker or a large institutional investor, such as a super fund or fund manager, lends shares they usually receive a ‘borrow’ fee’ and interest payments which generates passive income that enhances their portfolio returns.

Some investors operate under an investment mandate or set of rules that they follow when investing. An investment mandate can require the investor to be a long-term holder of shares and prevent them from trading the shares to take advantage of short-term price movements. In these circumstances borrowing shares allows these investors to trade the borrowed shares through their collateral accounts without changing their long-term holding. This ability to trade borrowed shares also allows long-term investors to offset or hedge the risk of poor performance from their long-term shareholding.

Market makers, such as brokers, often require the ability to borrow shares for day-to-day share trading. This is often the case for small-cap companies where there may be few shares available to buy on the open market. When a company’s shares can’t be easily be bought or sold on the open market, these companies and their shares are described as being illiquid. Market makers and institutional investors can lend and borrow shares amongst themselves as a way to trade illiquid shares.

Short selling, where traders attempt to profit from future price declines, relies on share lending and borrowing. A short seller will borrow shares, for a defined length of time, to sell on market in the belief they can buy them back at a lower price when they are required to return them to the stock lender. Short sellers can do this because the underlying owners of the shares agree to allow their broker or fund manager to lend their shares in exchange for a lower custodian administration fee.

IMPACT ON SHARE REGISTERS

Lending and borrowing of shares includes the transfer of beneficial ownership to the borrower. As such, it can result in significant movements in the beneficial ownership on a company’s share register, despite the ultimate owner of the shares not changing. The collateral accounts of some custodians may appear directly on registers and show regular changes in the size of their holdings as lending and borrowing positions are taken up or ended. Collateral positions may appear underneath the custodians named on the face of the company’s share register, however these positions have little visibility without further analysis. As institutions are the primary users of stock borrowing and lending, rises in the value of collateral holdings are often associated with decreases in institutional investment (and vice versa).

These collateral account movements can look like buying or selling by the investors whose funds are administered by custodians, when instead, these positions may be changing simply because of lending or borrowing activities. The in-depth beneficial ownership analysis of share registers conducted by FIRST Advisers is extremely valuable for companies as it allows greater visibility of ownership beneath the large custodians appearing on a register. This offers a much better understanding of the movement of borrowing and lending positions and how that may affect a company’s share price and trading volume.