Starting Out in Securities Lending

Securities Lending has been a hot topic for the past few years, but it can be very complex. Whether you are talking about trading on margin, short selling, or discussing financial events, you have likely heard the term. Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers is joined by Chief Strategist, Steve Sosnick to discuss the basics of Securities Lending.

Summary – Cents of Security Podcasts Ep. 56

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to the Cents of Security podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers. And today, I’m your host for the podcast. Our guest is Steve Sosnick, IBKR’s Chief Strategist. 

So today we’re going to be talking about securities lending. It’s been a hot topic for the past few years, whether you’re talking about trading on margin, short selling, or discussing financial events, it’s likely you’ve heard these terms.  

So it’s a very complex topic, and we’re going to try to talk about it in a basic sense so that we can help our listeners have a bit of a foundation for it. 

So welcome back to the program, Steve. 

Steve Sosnick 

Cassidy, great to see you again. 

Cassidy Clement 

So it’s not totally exactly what you do every single day, securities lending, but I know that you’ve written about it, been exposed to it. So what’s your background or experience with the topic? 

Steve Sosnick 

Well, the bulk of my career was spent as an options market maker, and it’s crucially important for someone who trades options professionally to understand the mechanics of stock lending.  

The reason being, it’s part of hedging. So if I’m long a whole bunch of calls, and I want to delta hedge that exposure, what I would want to do is short a certain amount of stock. But short selling is somewhat complex and very highly regulated, despite what you hear a lot of times online. And so, as a result it really does play into your way that you manage risk. And also it does come into the way that options are priced. 

I won’t get too deep into that one, but that does make a difference.  

So as a result, I always have had to work very closely with our stock lending area. We’ve taped some podcasts together as well, and we’ve done some educational stuff together as well, and so I’m very glad to have the opportunity bring this to a different audience. 

Cassidy Clement 

Yeah, I mean, most people who are into maybe financial news and not as deep into the weeds of options mechanics or anything like that, they’ve probably heard of margin or short selling or securities lending, especially in the last five years. It’s been a very popular topic.  

So if you were to explain more in the basic terms of what securities lending is and how it works functionally to our listeners. 

Steve Sosnick 

Okay. First of all, margin is a more encompassing term. Margin refers to any time you buy or sell stocks using borrowed money. Now you don’t have to use borrowed money to buy stocks. You could just pay cash and be done. Same with if you buy a put or a call option. You can do that just with cash on hand. 

The options tend to be done in a margin account because of various operational efficiencies, but you don’t need to borrow that money.  

When you sell a stock short, by definition, you are borrowing something. The reason being is, Cassidy, if I sell you a hundred shares of stock, and I sell it short, you don’t really know or care whether I’m buying it, whether I’m long the stock or short the stock. It should be transparent to you. It should actually be irrelevant to you.  

And so what happens though is if I’m long the stock, well, you buy a hundred shares from me, you have the hundred shares. I no longer have a hundred shares and we walk away.  

If I sold that stock short to you, I have to make good on that. Somehow, I have to fulfill your purchase. I have to deliver a hundred shares of stock to the clearing house the next day when the trade settles. And so, if I don’t have it, I have to go borrow it. 

There’s an old expression. “He who sells what isn’t his’n, buys it back or goes to prison”. Which is the 200-year-old way about talking about short selling.  

But in the modern era what I would do is I would ask our stock lending department to borrow 100 shares of stock to deliver to you.  

Now the vast majority of this stuff is done electronically and in an automated fashion. For starters, the firms maintain a list of stuff that’s called general collateral. Stocks that are easy to borrow. If it’s a hundred shares of any of your big household names, for the most part, it’s just there. 

And the cost to do that is relatively fixed. It’s basically around the Fed Funds Rate. And let me explain that for a minute, because if I’m borrowing the shares, somebody expects something. They’re not going to give it to me out of the goodness of their own heart. So I’ve got to give them something in return. 

If I sold the stock, I have the proceeds of that sale, I’m lending that money in exchange for borrowing the shares. And so the cost back and forth centers around Fed Funds Rates in most cases that we will need to get into the special cases because that’s where the fun starts. 

But for the most part, it’s a pretty seamless process. And this goes on all the time. Stock lending is a big source of funds. Funds are very commonly lending out their shares because there’s extra income for them. And so that’s why your big-name stocks for the most part are just what’s called general collateral. 

Brokerage firms, clearing firms, like ours, use this also as a source of financing and a source of funding and a source of P&L because we have access to the shares that we’re holding in custody and we will lend them out. And again, be able to borrow money against that or sometimes get a spread against it. 

But that’s really what it is short selling is using borrowed shares to fulfill the obligation that someone undertakes if they sell the stock short. Of course you sell the stock short because it’s the opposite of buying a stock long. You sell it because you think it’s going to go down. 

Although the economics are very different. And this is also very important. Number one, if when you buy a stock, especially if you do it for cash not using borrowed funds or margin, you lay out a certain amount of money and that’s the max you can lose. 

So in the case of this, you bought a hundred shares of something for $50 a share, you’re in for $5,000. That’s your max cost. That’s it. That’s all you can lose. And if it goes up your gain is unlimited. However far the stock goes, you can make that money. 

If it goes to $300 you’ve gone up six times and that’s fabulous. The economics are reversed for short sellers.  

Your maximum is set out the moment you Enter the trade. So if I sell those shares short to you at $50, the most I can make is $50 a share. And generally, make that last few cents or dollar. It just doesn’t end up working that way. 

So the amount of money, my profit is capped. My loss, on the other hand, is unlimited. If the stock goes up five, six times I’m on the hook for that because I’m going to have to buy back those shares at some point. So the economics are completely reversed. So those I think are some of the basics of stock lending. 

Cassidy Clement 

So you mentioned a little bit about the fees and some of the rates that are associated. So what exactly are the fees involved in this and are they fixed or variable or does it change per type of contract? 

Steve Sosnick 

This is where it gets more complex. If you’re selling short a hundred shares of, let’s say, McDonald’s, that rate is generally easy to do. It’s going to basically be somewhere around the Fed Funds Rate, plus or minus several basis points. 

And the rate isn’t going to change, as long as the Fed Funds Rate doesn’t change. If the Fed raises or lowers interest rates, that will change the terms of your loan because these are generally day to day loans, because you want to buy or sell back. 

You may want to buy back the stock any day. So technically they’re variable rate loans, but in reality the vast majority of them are more or less fixed within a short period of time. 

The problem comes in that group of names that are heavily shorted. And that’s where it gets very tricky. When you’re trading a stock, there’s the concept of the float. Again, in most stocks, it doesn’t matter to you. In the case of a heavily shorted stock, the float determines the rate to some extent, or the percentage of the float that is shorted really determines the rate.  

So let’s say there’s a stock with 10 million shares. Insiders hold a million of those shares or the company has it on their treasury stock. 

So the float in that case would be 9 million shares. Now let’s say there’s very little demand to short that stock. Doesn’t really matter. That falls into sort of the general collateral, but let’s say, for example, there’s some reason why short sellers have gravitated. And let me be very clear here, okay? 

There’s a lot of moralistic elements applied to short selling. And I’d like to make sure we get into this, but for now, all I’m going to say on the topic is it’s the inverse of buy low, sell high, and there really isn’t, to me, a moral argument to it.  

There’s certain times where you buy a stock because you think it’s undervalued, you short a stock because you think it’s overvalued.That’s really the judgment call that goes on there.  

And so if the market perceives, or if too many investors perceive that this company might be overvalued, you might run into some problems because to a very significant percentage of that float, in this case, I use the example, 9 million shares get shorted. Well, let’s say a million shares are shorted. Let’s say 2 million shares are shorted. Let’s say 3 million shares are shorted.  

Well, markets are smart this way. Investors are smart. The stock loan departments are smart. And they know that if there’s increasing demand, particularly relative to the shares outstanding or the float, the available float outstanding, like any other thing that you’re trying to borrow or monetize, it becomes scarce. 

And so that’s where the difficulties come in or that’s how, in many cases, the stock loan departments start to make their money. Because in the example before, where it was the general collateral, someone lends me the shares, I basically pay them Fed Funds, so be it. 

Well, if it becomes hard to borrow, that becomes a very valuable commodity for someone to lend. And so the rate starts to accelerate. And the rates actually start to be expressed as negative numbers because the person who’s borrowing it gets to borrow money for free. 

So in exchange, if it’s a hard to borrow stock, I may borrow those shares, but instead of getting a nice return on my money, I’m basically giving that money to you at 0% interest. Or I may actually even have to pay you interest to borrow those shares! 

And that’s when you start to get into the realm of hard to borrow. Those rates can be volatile. Those can change with supply and demand and as a result, sometimes if it becomes too expensive to borrow, people just say, what? I can’t make money on this short sale.  

The stock would need to go down some percentage every single day just for me to break even. I’m going to tap out. I’m going to buy back the shares. That’s when those situations become very volatile. 

The shares can become very volatile and the rates at which you borrow and lend can become very volatile. 

Cassidy Clement 

Everything that you’re mentioning has somewhat of an asterisk, I guess you could say, of, hey, this is super complex. Hey, there’s more to it than you think. So my next question is can anybody take part in securities lending, or is it more for a specific type of investor, or maybe somebody with some type of a financial license? 

I mean, honestly, before I started working here, I learned about it briefly in college, but with the meme stock craze in ‘20 and ‘21, even though I already have my Series 7, I never saw so much financial news about it until then. 

And it got me thinking, is this something that people are all flocking to or is this something that should be for those with more of an understanding of the market than the general retail investor? 

Steve Sosnick 

Stock lending is always done through an intermediary.  

What happens is, if you have a margin account, because the shares are held in what’s called street name, the broker owns them on your behalf, and part of the margin agreement is that they can lend those shares on your behalf. 

Some firms do it and don’t really give you any benefit for it. Other firms, such as ours, do rebate some of the proceeds from short selling back to you. So in that way, you’re engaging in the process, but indirectly. It’s not a market that individuals do. 

Your firm’s stock lending department does it on your behalf. And some firms are very good about really taking care of their customers. And I would say the two of us work for one such firm that’s particularly good at that. Others just basically keep the money for themselves and make it very difficult for you. 

And then of course, everything in between. 

So you’re not taking part in it. You alluded to the term meme stock and I was hoping not to get to it so quickly but the term shorts, short selling and short squeezes came into play a lot during the initial meme stock craze. 

And it keeps sticking its head up. There was a lot of information given out on social media. An incredible amount of it was wrong.  

This is one of the reasons why I wanted to sit down and do this with you and why I’ve done other podcasts and other educational stuff about stock lending, because it’s really misunderstood and it gets a moralistic spin on it, which I, again, I don’t think is appropriate to view it through those terms. 

But since you raised the meme stock comment, I’ll talk about it.  

One of the elements, to me, that set up what makes a meme stock is there was an element of nostalgia that was evident to millennials who were, in some cases, new to investing. In other cases, just had more time on their hands and the ability to do so and stimulus checks and the like got a lot of people into investing. And there became a sort of social media theme, I guess of how dare these people short these stocks that we were nostalgic for as kids?  

And GameStop, of course, being the poster child for it, AMC being another one, Bed, Bath Beyond, another one. Among the ones sort of in the early phases, and they’ve sort of faded as meme stocks, but they included Best Buy, they included Build-A-Bear Workshop, they included Nokia, they included Koss Headphones, which actually stuck its little ugly head up last week. And another meme stock craze. 

But the element was almost how dare these people bet against these companies? How dare these people root for these companies to go to zero, to go out of business? 

So let’s unpack a lot of that. Again, most short sellers aren’t rooting for the company to go out of business.That’s not really it. It’s very hard to make that last dollar or that last nickel. You have to hold on for a long period of time.  

What you’re saying is that this company, for whatever reason, is being overvalued by the market, when you could pick your valuation measure, price earnings or this company’s earnings. Or you have some reason to believe that the earnings are going to turn south or that there’s going to be bad news, you’re not taking a moral view that this company that you’re shorting is somehow wrong.  

The same token, there’s no reason to believe that whoever’s doing this, there’s no evil attached to it. It’s a financial calculation. Now, in the case of the original GameStop trade, which was probably the most successful short squeeze ever, let’s unpack that. 

So, you had this element online of how dare these people bet against this brick and mortar company that barely earns any money, if ever, and had a pretty high price earnings ratio and was pretty highly valued?  

Well, that’s the situation that naturally attracts short sellers. Again, I can’t speak for the main short sellers in that case, but I think it was much more of a financial calculus rather than let’s think of something nefarious here. But what was recognized, and I do have to tip my hat to Roaring Kitty on this one, because he did do his homework, is, remember I said that thing about the float? Well, in the case of GameStop, a very high percentage of the float was shorted.  

So, when enough people got on board, it was already expensive to borrow, then when enough people got on board and started buying the stock, it actually at first attracts more short sellers because the stock’s a little bit more overvalued so it gets even more expensive to borrow. 

Well then it becomes a self-fulfilling prophecy to some extent, if it metastasizes. And nothing’s ever metastasized like that, where the stock became essentially impossible to borrow. Those who hold stock in cash accounts, by the way, can inform their brokers that they don’t want to lend the shares. 

You can’t do that in a margin account, but you can do it in a cash account. So in some cases the available number of shares to short shrinks, in other cases it just gets so expensive and the stock starts moving, that it becomes too expensive to maintain the short. 

And then of course, that’s where the margin play comes in because if you’re short of stock and it doubles, well, you owe a lot of money because basically you have your collateral, the original amount of cash that you received is no longer sufficient to collateralize the shares. 

So then you get margin calls. The broker buys you in, the stock rallies more and  becomes a chain of events. And so to that extent, yes. That goes back to the adage I told you in the beginning. You have to buy it back eventually. 

And that becomes what’s called the short squeeze.  

And what I will say is short squeezes have been around for as long as there have been shorts. It’s just been a feature. It’s always been there. The meme stock era was probably the most egregious example. But in all cases, that becomes the situation. 

And one other term that you hear thrown around a lot, which I really want to disavow people of, is you hear the term naked short selling a lot. And the one thing I’ll say is that was a problem at one point. And naked short selling means you’ve sold the shares short and you haven’t borrowed them.  

You basically sold them short and knew you couldn’t borrow them, but you’re just going to sell the stock anyway. 

Well, guess what? The regulators got hip to this and there are very strict rules about locating your shares and delivering shares. So for example, brokerage firms maintain lists that are updated. Some places probably do it daily. Some places probably do it by the minute. 

And everything in between. Of stuff of stocks that are easy to borrow versus hard to borrow, or what might be problematic to borrow and can you deliver them?  

Now, because it’s a moving target, because two people might actually try to sell the stock at the same time and can’t borrow it. There may be situations where you can’t borrow the shares. 

But, you have very strict timeframes in which you have to cover that short or find or locate a borrow. You can’t leave a naked short out there.  

So whenever I hear people railing about like naked shorts, it generally to me is a bad sign. That to me means management is looking for someone to blame. 

And I will tell you flat out, you haven’t really been able to blame naked shorts for anything in the past. I forget when the legislation was approved, but let’s say 10, 15 years ago. It’s just not there. It doesn’t exist. It’s kind of a boogeyman in the sense that it’s someone convenient to blame stuff on. 

But I become very skeptical when I hear people blaming naked shorts for a problem. Yeah, there might be a lot of short selling, but eventually whoever’s selling that stock short has to come up with a way to borrow that stock back, or they’re forced to buy it back in the open market, which, by the way, is a good thing if you’re an investor in the stock, because that buying makes it go up. 

So, these are some of the terms you hear thrown around that are very misconstrued. 

Cassidy Clement 

You had mentioned within your answer there about, I think it was like, easy to borrow, hard to borrow. Highest to borrow is another one, I think, that’s like, what is the most expensive? 

But what are some reports or indicators that people should pay attention to if they want to be involved in this type of investment or following this type of investment? 

Steve Sosnick 

Well, one of the things that we do at Interactive Brokers is you can query our system for what the appropriate rate is. 

First of all, you can basically see what the rebate is, because that’s sort of the term used when it becomes hard to borrow. Is there a rebate? Or what is your cost to borrow these shares? And you could query the Trader Workstation and do that. Also, one of the most popular pieces on Trader’s Insight via IBKR Campus, there’s basically a piece put out, IBKR’s Hottest Shorts, I think is the exact title, and I’m not sure the exact title but something to that effect. 

And that’s basically a periodic report from our stock loan department of what’s difficult to borrow? What’s seeing the most activity in that regard? So that’s probably your best ways to do it.  

The exchanges do put out reports on net shorts. NYSE does it, NASDAQ does it. They’re done twice a month and with a delay, so they’re kind of not all that useful. So they are useful to a point. And one place they’re very useful is they come up in what’s called the days to cover ratio.  

Now, again, this is not a moving target number. But if the report says that there are a million shares shorted and the average daily volume in the stock is 100,000 shares, well that requires 10 days of volume to cover your short. 

Your days to cover is 10, if you can find that statistic. Some data vendors put it out, some don’t.  

If you can figure out the days to cover ratio, those with a high days to cover ratio become more prone to short squeezes, because again, there’s a lot of latent demand out there if the stock rallies. 

Or just late in demand even if the stock falls, they’re going to want to cover and take their profits. So days to cover is an important ratio.  

The same situation, if there’s a million shares shorted but the stock trades 20 million shares a day, that’s really inconsequential. It’s not likely to move the stock. The activity of short covering is not likely to make a big dent in the stock price in and of itself. So that’s an important one too. 

Cassidy Clement 

When we’re looking at risks in investment, obviously there’s specific ones for different types of asset classes or maybe your strategies. But for securities lending specifically, are there certain things that investors should ask themselves before getting involved in this type of investing? 

Are there certain risks to look out for? I mean, obviously, there’s still taxes, there’s still like potential loss, there’s still potentially, I’m not sure if it’s SIPC or what it is for insurance coverage and margin calls. There’s a lot.  

But from your perspective, what’s the overall bullet list to ask yourself before you start to maybe expose yourself to this type of investment? 

Steve Sosnick 

Number one is, do I really understand what I’m doing here? Because again, it’s investing turned on its head. It’s sell high, buy low. And as a result, as I mentioned earlier, your potential gains are capped and your potential losses are unlimited.  

And you’re always borrowing something. So there’s always leverage involved, whether you want there to be or not. And so these are very important considerations and it’s very different than buy and hold investing. You can’t really buy and hold on the short side.  

The other thing also is and consult your tax preparer on this one, but I’m pretty sure that if you hold a short for longer than a year, which can be, of course, quite expensive, it’s still a short-term capital gain. Not a long-term capital gain. 

So, you don’t even get that benefit that you would get if you hold an investment for a year. And just in terms of can you lend out your shares and get a rebate for it? That’s not really something you need to concern yourself with. 

It’s like an added little benefit. Do you want to maybe buy shares that are in demand so that you can lend them out and earn that excess rate of return? Well, maybe, but those shares tend to be the most risky shares to own and to trade anyway. Again, you’re entering into some high-risk waters. 

Even plain vanilla short selling has just a little extra degree of difficulty. And then if you start to get involved in some of the more advanced concepts or trying to front run short sellers or trying to get involved in people trying to create a short squeeze, you’re getting into some treacherous waters. 

And as I pointed out, for example, in this latest GameStop run, there was sort of the theme of, oh, wait, let’s go squeeze the shorts now. Well, there weren’t a lot to squeeze. And, when I did the math as of last week, if you bought and held GameStop after the initial, I think it was May 13^th was the run up. 

Or if you bought Chewy after the day that the investment was sort of disclosed via Cartoon Dog, you’re down. You couldn’t buy and hold those things. Because there really wasn’t this material amount of shorts to be squeezed. You actually would have made money potentially by shorting the stock. Chewy a little bit easier. 

It would have been hard to make money on the short side in GameStop too, because there were some days where the stock doubled and then fell back. And so your timing would have been very difficult and the borrowing costs were high and fluctuating wildly. 

So it can be tempting, but it’s really it’s not for beginners and it’s not for people who are poorly capitalized. You need a certain amount of risk tolerance. You need a certain amount of savvy. And it behooves you to be well capitalized if you’re going to undertake this activity. 

Remember, you’re not undertaking the stock lending per se. Again, if you have the margin account, you’re lending it or you’re not lending it based on what the demand is. The only way you can really try to exploit it is to go long some of these stocks that may have very severe negative rebates. But be very careful because there’s a reason why these stocks have these very difficult rebates and they’re going to fluctuate. 

So that’s not a buy and hold situation either. 

So there’s a lot of moving parts and I think it’s important to understand it. I think it’s important to understand the mechanics of it that there’s always a borrow involved. So something is always being borrowed and lent. The shares versus money. 

And I think two very important things that I think get mischaracterized are, number one, to me, it’s not moral or amoral or immoral. You’re just trading. You’re just buying or selling shares.  

Whoever’s doing this is not evil. And particularly when you hear somebody blame naked short sellers for problems in whatever stock it is, that’s generally more of a cover up than it is actually a legitimate excuse.  

And that’s really trying to paint people who have a legitimate investment view that happens to be negative in a very poor light to try to demonize those people, because it turns out there’s of crying wolf when it comes to naked short selling.  

Cassidy Clement 

Well, hopefully, at a minimum, everybody listening has retained that it’s a very complex topic with a lot of moving parts that you need to research and definitely vet your own investment profile, if you will, or financial profile, because as you mentioned, even the most plain version of what we’re speaking about today still involves a high level of risk. 

You have to make sure that you’re capitalized correctly. And, hopefully you have done your research and we have our securities lending reports and our hottest shorts reports and all of that on IBKR Campus.  

But otherwise, you brought up some really good points today. Thanks for joining us, Steve. 

Steve Sosnick 

Pleasure, Cassidy. Talk to you soon. 

Cassidy Clement 

Sure. So as always, listeners can learn more about an array of financial topics for free at ibkrcampus.com. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening, everyone. 

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