Understanding Stock Loans: Process and Mechanism

If you are new to the world of stock market investment, you may have come across the concept of “stock loan“. But, what is a stock loan? How is it done? Does this mean you can take out a loan to buy stocks? Given the doubts and questions that may arise, we are going to clarify this term to help you understand how you could benefit from stock loans.

Before delving into the details, it's important to understand the origins of stock loans, which are closely linked to the role of brokers. Brokers are finance professionals who facilitate transactions between buyers and sellers of stocks, safeguarding their interests. Sometimes, due to limited resources or the need to complete transactions efficiently, brokers began utilising stock loans, which proved to be quite beneficial for them. Now, let's explore how a stock loan is structured.

stock loan

What is a loan stock?

A stock loan, also known as “securities lending,” is a practice where an investor borrows shares of stock, typically from a brokerage or an institutional investor. The borrower agrees to return the stock at a later date, possibly paying a fee or interest.

This practice is part of securities lending concept, which means you can essentially borrow many other securities, including commodities, derivatives, and others.

What's the purpose of a stock loan or securities lending?

This arrangement is often used by investors who want to sell the stock short, meaning they borrow the stock and sell it with the hope of buying it back at a lower price in the future to return it to the lender. This way, they profit from the difference if the stock price goes down.

For the lender, stock loans generate extra income through the fees or interest charged to the borrower. It's important for lenders to be aware of the risks, like the possibility of the borrower not being able to return the stock. For the borrower, the main risk is the price of the stock increasing, which would lead to a loss when buying it back at a higher price to return to the lender.

Types of stock loans and the importance of consent

Essentially, investors can borrow stocks or securities from their brokers. However, brokers can also borrow securities from their clients.

Stock loan with or without client's consent?

In most cases, a broker cannot borrow a client's stocks without obtaining explicit consent. However, when you open a brokerage account, you typically sign an agreement that includes various terms and conditions. Some of these agreements contain a clause that allows the brokerage to lend out your securities (stocks) to other parties, such as short sellers.

The ability of a broker to lend your stocks usually hinges on your consent, often provided when you agree to the terms of a margin account. Margin accounts, as opposed to cash accounts, typically include provisions that allow the lending of securities.

When stocks are lent out, the borrower provides collateral to the lender (your broker), and your ownership rights are generally maintained. This means you still receive any dividends and have the same financial interest in the stock. If you decide to sell your shares, the broker is responsible for ensuring they are available for you to sell.

In the UK, the FCA sets out rules and guidelines for financial services firms, including those relating to the lending of client assets like stocks. These regulations require firms to act in the best interest of their clients and ensure that clients are treated fairly.

Under the FCA's Client Asset Sourcebook (CASS), there are specific rules concerning the holding and control of client assets. These include requirements for obtaining explicit consent from clients before their assets can be lent out and ensuring that clients are fully informed about the risks and implications of their assets being lent.

The GameStop example: short-squeeze

Many hedge funds and institutional investors had short-sold GameStop shares, betting that the company's stock price would fall. To short-sell, they borrowed shares of GameStop and sold them, planning to buy them back at a lower price.

Due to the poor situation of the company and its outdated business model, the company was going downhill, trapping a large number of shareholders who did not want to sell for fear of losing 40%, 50% or 60% of their investment.

The short-selling of GameStop involved borrowing shares from brokers or other investors, which is where stock loans come into play. These loans enabled short-sellers to sell shares they didn't own.

In GameStop's case, many retail investors, organised mainly through online platforms like Reddit, started buying the stock in large quantities, driving up its price. Then, the price began to rise, forcing short-sellers to buy back shares to cover their positions, further driving up the stock price.

The GameStop event caused significant market volatility and highlighted the risks associated with short-selling and stock loans. It demonstrated how coordinated actions by a large group of retail investors could impact the market and cause substantial losses for short-sellers.

What are the characteristics of stock loans?

When shares are loaned out, it's true that the lender temporarily loses voting rights associated with those shares. The borrower of the shares, typically someone who intends to short sell, does not gain these voting rights. The decision-making power in terms of corporate governance associated with the shares is temporarily suspended until the shares are returned.

As a lender, you generally retain the right to any economic benefits like dividends during the loan period. However, these are typically compensated for by the borrower through payments equivalent to the dividends (called dividend equivalents).

In a stock loan, the lender earns income through fees or interest paid by the borrower. The lender does not directly benefit from the trading activities (like profits or losses) of the borrower.

While stock lending can be mutually beneficial, it's not guaranteed that both parties always win. The lender earns additional income through fees, but there are risks like counterparty risk (the risk that the borrower fails to return the shares). For the borrower, if their strategy (such as short selling) doesn't work out, they can incur losses.

Stock loan features

  • The obligation of the borrower to return the assets at the agreed time: In a stock loan, the borrower is obligated to return the borrowed shares at the end of the loan period or upon the lender's request, depending on the terms of the agreement.
  • The borrower temporarily gains the legal title to the shares, allowing them to sell or transfer the shares as part of their investment strategy (e.g., short selling). However, it's important to note that this transfer of ownership is temporary.
  • The lender retains rights to the economic benefits of the shares, such as dividends. In practice, if dividends are paid while the shares are on loan, the borrower usually compensates the lender with equivalent payments.
  • Voting rights are suspended until shares are returned.

Where can I find information about borrowed shares?

The FCA's website provides detailed information about short selling, including regulatory updates and notification requirements. They regulate short selling and certain aspects of credit default swaps (CDS) in the UK, with specific rules and guidelines for notification and disclosure of net short positions. The FCA's website includes updates on the Short Selling (Notification Threshold) Regulations and other relevant regulations​.

Also, the Short Tracker includes data on short positions in various companies held by different fund managers​, including useful information such as the most shorted companies.

The risks of stock loans

It's also worth mentioning that while the lender earns income through the loan (in the form of interest or fees), there are inherent risks involved, such as counterparty risk (the risk that the borrower cannot return the shares). For the borrower, the risk lies in the possibility of the share price moving against their strategy.

Learn more about stock investing

Summary

In summary, stock loans are part of securities lending. It means lending out your stocks, which are used for short-selling strategies. Although this can be beneficial, it also carries risks. Many brokers nowadays, including the best brokers for CFDs, allow short-selling, which means you can borrow funds from your broker to short-sell assets via derivatives to benefit from price declines (bear markets).

FAQs

What are the benefits of a stock loan?

The main benefit of a stock loan is the ability to access cash without selling your investment. It also allows you to potentially benefit from any appreciation in the stock value during the loan period.

What happens if I can't repay a stock loan?

If you cannot repay the loan, the lender has the right to sell the stocks used as collateral to recover their money.

What is the difference between a stock loan and loan stock?

A stock loan involves borrowing money against the shares you own, whereas loan stocks refer to debt securities issued by a company. Loan stocks are a form of borrowing by the company from investors, who receive interest in return.

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