When hedge funds and traders have short positions, the underlying shares need to be borrowed. Prime broker’s securities lending departments enable their clients to borrow securities directly from a prime broker to reduce financing costs and the risk of holding a long-term short-position.
Find A Prime Broker For Securities Lending
How to choose a prime broker for securities lending
Securities lending can help hedge funds, family offices and asset managers earn additional income from long-term holdings or obtain the shares needed to support short-selling strategies. However, the quality of a prime broker’s lending service can affect revenue, borrowing costs, trade execution and risk.
When comparing providers, hedge funds should look beyond the headline lending rate. Important considerations include the breadth of the broker’s lender and borrower network, availability of hard-to-borrow securities, collateral arrangements, revenue sharing, recall procedures, reporting and the legal protections applying if a counterparty defaults.
It is also important to distinguish between the two sides of securities lending. An investor can act as a lender and earn income from fully paid holdings, or as a borrower obtaining securities for a short sale, settlement requirement or other trading purpose.
What is the purpose of securities lending in prime brokerage?
Securities lending is the temporary transfer of shares, bonds or other securities from a lender to a borrower. The borrower provides collateral and pays a fee. Although legal title passes during the loan, the transaction is intended to be temporary, and the borrower must return equivalent securities when the loan ends.
Within prime brokerage, securities lending serves two main purposes.
For borrowers, it provides the stock or other assets required to settle short sales. A hedge fund that believes a share price will fall cannot normally complete a short sale unless its broker can locate and borrow the relevant shares. The availability and cost of that borrow can materially affect whether the trade is practical or profitable.
For lenders, securities lending creates a potential source of additional income from assets that might otherwise remain idle in a long-term portfolio. The investor continues to retain economic exposure to the security, while receiving a share of the lending revenue.
The prime broker sits between market participants by locating inventory, matching lenders and borrowers, negotiating rates, arranging collateral, managing recalls and administering payments. An extensive network can be valuable because lending fees are driven by supply and demand. Widely available securities may generate little income, while scarce or heavily shorted shares can command much higher rates.
What clients use prime brokerage securities lending?
Securities lending is used by clients on both sides of the transaction.
Typical lenders include:
- Hedge funds with long positions that are not being actively traded.
- Single and multi-family offices holding substantial equity or bond portfolios.
- Asset managers, investment funds and exchange-traded funds.
- Pension funds, insurers and sovereign wealth funds.
- Endowments and foundations with long-term portfolios.
These investors may lend fully paid securities to generate incremental portfolio income. The opportunity is generally more relevant when a portfolio contains assets for which there is meaningful borrowing demand.
Typical borrowers include:
- Long/short equity and market-neutral hedge funds.
- Event-driven and merger-arbitrage funds.
- Market makers and liquidity providers.
- Proprietary trading firms.
- Brokers facilitating client short sales.
- Investors hedging an existing exposure or implementing relative-value trades.
For these clients, access can matter as much as price. A fund may identify an attractive short opportunity but be unable to trade it if its prime broker cannot locate the shares. A borrow can also become uneconomic if demand pushes the fee too high or if the lender recalls the position at an inconvenient time.
Interactive Brokers’ Securities Lending Dashboard is designed mainly to help clients assess the borrowing side of the market. It provides data such as utilisation, borrower depth, lender depth and average loan duration. Premium data adds short-interest indicators, on-loan quantities and values, days to cover and 12 months of historical information.
IBKR clients can also use its Securities Loan Borrow system to search for shortable securities by symbol, exchange, ISIN or CUSIP and view the available quantity, number of lenders and indicative borrowing rate. This information can help a manager judge how difficult a security may be to borrow and whether a short position faces crowding or squeeze risk.
What is the downside to securities lending?
Securities lending can produce additional revenue, but it is not risk-free. The main disadvantages are:
Counterparty and collateral risk
The borrower may fail to return the securities. Collateral is intended to protect the lender, but a shortfall could arise if markets move sharply, collateral loses value or there is a delay in liquidating it. Managers should understand how often collateral is valued, the applicable margin and who acts as counterparty.
Recall and settlement risk
The lender should ordinarily be able to recall or sell loaned securities, but their return may not always be instantaneous. A delay could interfere with a sale, voting deadline or portfolio change. The agreement should explain recall times, failed-return procedures and compensation for settlement problems.
Uncertain revenue
Lending income is variable and cannot be guaranteed. It depends on borrower demand, available supply, market conditions and how the broker shares revenue. Easy-to-borrow holdings may earn very little, while the highest fees often arise in volatile or heavily shorted securities.
Tax treatment of substitute payments
When a security is on loan, dividends or interest may be replaced with manufactured or substitute payments. These can receive different tax treatment from the original income, depending on the investor, instrument and jurisdiction. A fund or family office should obtain tax advice before joining a programme.
Operational and legal complexity
Securities lending requires accurate collateral management, reconciliations, corporate-action processing and reporting. The governing agreement should specify rights on default, permitted collateral, valuation practices, investment of cash collateral, fees and any indemnification provided by the broker.
Short-selling and reputational considerations
Loaned securities may be used to facilitate short selling. Some asset owners are uncomfortable lending shares that could be used to bet against companies they own. Lending policies may also need to reflect stewardship, environmental, social and governance commitments.
Cash-collateral reinvestment risk
If cash collateral is reinvested, the investment can lose value or become illiquid. This was an important source of losses in previous periods of financial stress. Managers should establish who controls collateral investment, what restrictions apply and who bears any loss.
Should you enable securities lending?
Enabling fully paid securities lending may be worthwhile for a hedge fund, family office or asset manager with a sizeable portfolio of long-term holdings, particularly where some securities are in strong borrowing demand. It can turn otherwise idle assets into an additional source of revenue without requiring the portfolio to sell its underlying positions.
It is less compelling where expected income is small, the investor needs uninterrupted voting rights, securities are traded frequently or the legal, tax and counterparty risks outweigh the likely return.
Before enabling a programme, ask your prime broker:
- Which securities in the portfolio are likely to be borrowed and what have comparable positions earned?
- What proportion of gross lending revenue does the client receive?
- Are programme, custody, administration or other fees deducted?
- Who is the legal borrower and does the broker indemnify the lender against default?
- What types and levels of collateral are accepted?
- How frequently is collateral marked to market and when are margin calls made?
- Who holds and, where relevant, reinvests cash collateral?
- How quickly can securities be recalled or sold?
- How are dividends, interest and corporate actions handled?
- What reporting is provided for loans, rates, collateral and revenue?
- Can the client exclude particular securities or recall shares for voting?
- What are the tax implications of substitute payments?
A useful test is to request a portfolio-level revenue estimate based on historical demand, then compare the expected net income with the risks and operational burden. The estimate should not be treated as guaranteed, because lending rates and utilisation can change rapidly.
What is the best prime broker for securities lending?
Interactive Brokers focuses on securities-lending intelligence for investors evaluating short trades. Its dashboard may be especially useful to active managers that want real-time indications of utilisation, lender and borrower depth, short interest, days to cover and available stock. Its separate search facility shows indicative borrow rates and inventory for securities a client may wish to short.
How to choose a securities-lending prime broker
The final assessment should cover five areas:
- Economics: Compare gross rates, revenue splits, borrowing fees and all related charges.
- Market access: Examine the depth of the broker’s lender and borrower network and its ability to source difficult securities.
- Risk controls: Review counterparties, collateral, margining, indemnification and default procedures.
- Operational service: Test recalls, settlement, corporate actions, reporting and integration with the portfolio-management system.
- Transparency: Require position-level reporting showing loans, rates, collateral, gross revenue, deductions and the client’s net return.
Securities lending should not be treated as free money. Used selectively and supported by strong controls, it can improve portfolio returns and facilitate investment strategies. Used without understanding collateral, recall, tax and voting implications, the incremental income may not justify the additional risk.