Securities lending is a long-established practice in capital markets that has until now been largely confined to big financial institutions, even though every owner of stocks, bonds and ETFs has the right to lend them. As a consequence, most asset owners know little about this lucrative practice, which has become a global industry with a massive $2tn of assets on loan on a daily basis. Here are some of the intricacies that make this such an exciting space:

1. Securities lending has been going on for over 40 years. The first formal equity lending transactions took place in the City of London in the early 1960s but it really took off as an industry in the early 1980s. The practice has evolved from a back office operation to a common investment practice that enhances returns for big financial institutions.

2. Securities lending plays an important economic function in capital markets.

It brings greater liquidity and efficiency to the market, can help facilitate the settlement of certain trades, promotes price discovery and facilitates market making.

It also plays a critical role in derivatives trading, certain hedging activities and other trading strategies that involve short selling.

3. Securities lending can be a great source of alpha, and a way to earn from the hidden value of your portfolio. Earnings from lending is dependent on the level of availability of your stocks. The more widely available stocks, known as ‘general collateral’, generally produce lower returns, of up to 0.5% (50 bps).

Hot stocks, known as ‘specials’, can command much higher returns varying from 1.0% (100 bps) to over 100% (10,000 bps) annually in more extreme cases.

4. Sometimes short-sellers are right. They spotted trouble with construction company Carillion long before anyone else. A year prior to its collapse, Carillion was the FTSE 250 most shorted stock, which should have sounded alarm bells.

Sometimes they are wrong. They can misinterpret the present or future business of a company, as we saw with online supermarket Ocado. A share surge in early 2018 which wiped out $382m for short sellers. At the end of the day it’s not the short sellers who dictate the long-term direction of the stock but the performance of the business itself.

5. Did you know that many fund managers, active or passive, already engage in securities lending to help boost a fund’s performance or offset its costs? This has helped keep index fund charges down, which is hugely important in an age where the hunt for alpha has taken more importance, and in an age where fees are under the microscope.

6. In general, securities lending has negative beta to market conditions, with all things being equal. When stocks rise in a bull market, demand to borrow securities wains and lending rates are lower, but you do enjoy the appreciation of your assets. On the other hand, in bear markets (when stocks depreciate) demand to borrow stocks increases and so do lending rates. This way you benefit from a new stream of income to mitigate the volatile times.

7. Demand for borrowing ETFs is growing exponentially. With the huge swing towards passive investing over the past decade or so, currently there are over a 100 ETFs returning more than 2.0% (200 bps) to lenders.

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