What Is Fully Paid Lending and How Does It Work?

Fully paid lending is a segment of the securities lending market where investors can generate income by temporarily loaning out their eligible securities. This practice involves an investor’s brokerage firm borrowing fully paid shares from their account and then lending them to other market participants. Securities lending is a long-established practice that facilitates various trading strategies and contributes to market liquidity.

Understanding Fully Paid Lending

Fully paid lending involves shares an investor owns outright, purchased with cash and not on margin. This distinction is important because it differentiates them from securities purchased with borrowed funds, which are already subject to different rules. Participation in such a program is always optional, requiring explicit consent from the investor.

A brokerage firm’s primary purpose for fully paid lending is to meet demand from borrowers in the securities market. These borrowers need shares for short selling, trade settlement, or other sophisticated trading strategies. By lending these securities, brokerage firms generate income from borrowing fees, sharing a portion with the lending client. This activity contributes to market liquidity.

From a client’s perspective, the main objective is to earn additional income on their existing stock holdings. This income accrues daily and is typically paid monthly, providing a supplemental revenue stream.

How Fully Paid Lending Works

The process begins with the broker identifying eligible shares within enrolled client accounts that are in demand by borrowers. Brokers evaluate factors such as borrowing demand, the overall available supply of the security, and general market conditions to determine which shares to loan. Once identified, the broker facilitates the lending transaction, acting as an intermediary between the client and the market participant.

Collateral provided by the borrower to the broker secures the client’s loaned securities. This collateral typically consists of cash or highly liquid securities and is held at a third-party custodial bank, separate from the broker’s assets. Regulatory requirements, such as those under SEC Rule 15c3-3, mandate that this collateral must fully secure the loan, usually at a value equal to or greater than 100% of the loaned securities’ market value, often ranging from 102% to 105% to account for market fluctuations.

The value of the loaned securities and the collateral are marked to market daily, ensuring that the collateral levels remain sufficient throughout the loan period. If the value of the loaned securities increases, additional collateral will be required from the borrower to maintain the agreed-upon percentage. The interest rate paid on loaned securities is variable, influenced by market demand and supply for that specific security, and can change at any time based on these conditions. This daily accrual of interest forms the basis of the income shared with the client.

Clients retain the right to recall their shares from the borrower at any time. This recall can occur if the client decides to sell the shares or wishes to have the securities returned to their account. Upon a recall request or sale, the lending agreement is terminated, and the shares are returned to the client’s direct possession, usually within a few business days.

Participating in Fully Paid Lending

Clients typically opt into a fully paid lending program by signing a Master Securities Lending Agreement (MSLA) with their brokerage firm. This agreement outlines the terms and conditions of the lending arrangement, including how payments are calculated and distributed. Eligibility criteria often apply, such as maintaining a minimum account balance.

Income from fully paid lending is calculated daily based on the market value of the loaned securities and the prevailing interest rate for that security. This accrued income is credited to the client’s account monthly. The specific percentage of the lending fee shared with the client varies by brokerage firm and the demand for the security.

While shares are on loan, clients maintain economic ownership, meaning they still benefit from any capital appreciation or depreciation of the security. However, the legal title and voting rights for the loaned shares are temporarily transferred to the borrower. Clients generally cannot exercise voting rights on shares that are out on loan, though they can recall their shares to regain these rights if they wish to participate in a proxy vote.

Regarding dividends, if a security on loan pays a dividend, the client will receive a “cash-in-lieu” payment from the borrower rather than the actual dividend from the issuer. This substitute payment may have different tax consequences than qualified dividends, typically being taxed as ordinary income at the client’s marginal tax rate, which can be higher than the preferential tax rates for qualified dividends.

Shares on loan are generally not covered by Securities Investor Protection Corporation (SIPC) insurance, but the collateral held by a third-party custodian provides a layer of protection against the borrower’s default.