Stock lending, short selling, and ETFs

Everyone knows ETFs are getting cheaper. At the time of writing, the annual fee for some plain vanilla ETFs is close to zero. If pricing trends continue, in a few years' time some ETFs may cost absolutely nothing.

But ETF issuers have to make money somehow. And it's stock lending that allows ETF issuers to charge close to nothing for these new ETFs.

What is stock lending?

Stock lending is, as the name suggests, the lending of stocks. ETFs, like every fund, have stocks in them, which the fund's managers can lend out. ETFs are very attractive for stock lenders because they have large holdings and little trading activity - meaning there are many idle stocks which can easily be lent out. (This is different, say, from some mutual funds where there is heavy churn and fewer stocks.)

Stock lending is common and widespread. In 2016, for example, the global value of stocks on loan at one point in time exceeded $2 trillion. [cite] It is also very important because it provides an additional source of revenue - around 3 basis points per ETF, according to Vanguard - in a time of declining fee revenue.

How it works: the mechanism

In a typical lending scenario, the potential borrower of a stock - usually a large financial institution with a view to short selling - goes hunting for a potential lender. The potential borrower rarely goes looking for a lender directly. Rather, they go through agents, such as broker-dealers, who can connect them to a lender. (The agent will then take a share of the rental fee, usually 30 percent).

When a borrower has found a lender, the lender requires the borrower to post collateral before they agree to lend them the stock, this way the lender has security if the borrower defaults. The lender will also spell out the terms of the loan. This includes the loan's duration, how much rent the borrower must pay, and an agreement to pass any dividends or coupons a stock pays on to the fund.

Unwinding the loan is the reverse process. The stock borrowed is returned to the fund from which it was borrowed. Collateral is then released via the agent who arranged the loan. All fees are then settled.

Stock lending: what investors should know.

How much of an ETF's holdings are lent out depends, in the first instance, on the issuer. Some issuers have policies in place limiting the amount that can be lent out - with typical limits varying from 30 to 50 percent. Others - but very few - have policies prohibiting securities lending altogether. Such limits are subject to change and purely voluntary. As a rule of thumb, its safest for investors to assume that their ETF issuer will engage in stock lending and that it can lend at least 50% of its holdings out.

Another important consideration for investors is what lending model their ETF issuer is using (if it is possible for them to find out). Here, Vanguard divides stock lending into two kinds models: value and volume. Value involves lending out stocks that few other issuers are lending out. This means they attract a "scarcity premium" and higher rental fees can be charged. Volume lending, by contrast, is picking stocks that are most likely to get lent out, meaning an issuer can maximise the number of loan transactions made.

Here, it can be worth noting that academics have found that issuers tend to hold stocks that are most likely to get lent out (whether for value or for volume reasons). That is, ETF issuers skew their funds' holdings towards what short sellers want to borrow.

As well as between issuers, lending also varies between ETFs. ETFs with different holdings engage in different degrees of securities lending. As another rule of thumb, ETFs that hold government bonds are extremely likely to engage in securities lending. Government bonds are the most borrowed stocks around the world - by far. According to a recent study around 40% of all stock lending is in government bonds.

Risks: what investors should know

For a full discussion of risks and collateral: see this article on collateralisation

There are two kinds of risks involved in stock lending: borrower default risk and collateral re-investment risk.

Borrower default risk is when the borrower cannot return the stock they've borrowed. Most often, this is because a short-seller's (and borrowers are usually short sellers) gambit has backfired and the stock they borrowed, rather than tanking, rallies strongly, forcing them to default.

How often does this happen? Very rarely. According to BlackRock, since the company's founding in 1981 there have only been three cases of borrowers defaulting. And in every case, BlackRock says, they were able to repurchase the stocks borrowed with collateral posted.

There are also safeguards. Stock exchanges and industry practice almost always require that short sellers post collateral exceeding the value of anything they've borrowed. In the United States, industry practice dictates that collateral exceeds 102% of the value of the stock borrowed. Rules are very similar in other countries.

Collateral re-investment risk occurs because ETF issuers tend to lend out the collateral they receive, as well as the stock. This is usually into low risk money market funds. Here the danger is that a financial crisis - or some other event - can wipe out the value of the collateral. This happened during the 2008 financial crisis, for instance. Such situations are rare, but do happen.

Criticism of stock lending

The major criticism of stock lending is about who gets the spoils. Some say that the gains (the rental fees charged to borrowers) should go to investors - not the issuers. After all, it's the investors assets being lent out and investors who ultimately bear the risk. (Here it can be worth noting that some issuers do in fact offer investors the spoils of stock lending.)

But this coin has two sides. Stock lending is what enables big issuers to offer ETFs at such low costs. They are, after all, commercial entities and they have to make money somehow. If they don't do that through management fees, it has to come from stock lending, they say. It is stock lending that makes free ETFs free.

Another major criticism is that stock lending blurs the distinction between physical and synthetic ETFs. Synthetic ETFs expose investors to counterparty risk because they're based on swaps. Thus if the swap provider defaults, then the synthetic ETF goes bust with it. But stock lending complicates this. Because physical ETFs lend out their stocks and the collateral backing it up, investors are exposed to the same sort of counterparty risks you'd find in a synthetic ETF. That is, they can lose their stock and collateral in the type of event, like a financial crisis, that would threaten the solvency of a giant investment bank that provides the swaps.