Important information: Participating in share lending carries risks. Share lending returns vary month-to-month. Read more about these risks below.
Key terms
Share lending: The practice of loaning shares out to others in exchange for a fee.
Share lending yield: The annualised return a customer receives from participating in share lending.
Calculated as:
(Monthly cash distribution received / ave market value of eligible shares) * 12
Example:
(£0.10 / £1,000) * 12 = ~ 0.0012 or 0.12%
Eligible shares: All UK and US shares held in a General Investment Account (GIA) or Self Invested Pension Plan (SIPP). This includes ETFs and investment trusts. Shares held in ISAs are not eligible for share lending. We do not currently lend European shares or ETFs which have been assigned low risk ratings by their manufacturers.
Income distribution: Participants in the share lending programme will receive 50% of the income generated when their shares are on loan, after lending partner fees are deducted.
What is share lending?
Share lending plays an important role in global financial markets, creating liquidity, as well as enabling hedge funds and other investors to engage in short selling strategies.
The practice in its current form began to take shape in the 1960s, when institutions called market makers began borrowing shares to settle sales on behalf of their clients.
In the following decades, the practice became more common, as mutual or “long only” funds began lending shares that they held to offset custody fees.
Since the Global Financial Crisis, share lending has undergone significant standardisation and global regulators have introduced measures to oversee the practice, adding significant protections for lenders and borrowers.
Today, the biggest lenders of shares include ETFs, pension funds, and insurance companies. Borrowers are typically banks, hedge funds, or brokers that need shares to “sell short”, support settlement, or to facilitate market making.
At a high level, a lender temporarily transfers ownership of shares that they hold to a borrower. In return, the borrower will transfer cash or other high-quality and liquid assets (like government bonds) to the lender. In return, the borrower will pay a fee to the lender.
That’s the top level overview. Let’s dive a little bit deeper.
What do these terms mean?
The lender:
Normally in the market, this would be a mutual fund, ETF, pension fund, wealth manager, stock broker, or insurance company that owns a portfolio of shares. If you look at the fact sheet for an ETF there is typically a section that says how much of a return has been generated by share lending.
In our case, the lender would be you, our customer. Our customers lend the stock to Freetrade, and we then lend it on to our counterparty.
The borrower:
Borrowers may want to borrow shares for a number of reasons; these include borrowing in order to facilitate short selling, to help make their settlement process work more efficiently or for hedging purposes. Borrowers could include investment banks, hedge funds and broker-dealers. Freetrade will only lend to institutions with high credit ratings, like large global investment banks.
Collateral:
Collateral basically means the financial instruments that the borrower provides to us in case they fail to return the shares.
Freetrade requires borrowers to provide us with high-quality government bonds for the duration of the loan. We will check each day to ensure that the collateral will be at least equal to the value of shares on loan, and will request additional collateral if necessary.
Why would someone want to borrow shares?
If it is so easy to buy shares in the market, what is the point in borrowing them? There are a number of reasons why a borrower would want to borrow shares. This includes:
● Enabling investment strategies such as short selling
● Enabling market makers to quote continuous two-way prices
● Supporting settlement efficiency
But is that a good thing? The reality is a bit more nuanced.
On the one hand, short selling can increase downward pressure on the price of shares that you own.
On the other hand, markets benefit from share lending as it provides additional liquidity and helps price discovery in the market. This makes markets more efficient, which benefits both companies that want to raise money and investors. But don’t just take our word for it. It is the government’s view as well:
‘The government sees short selling as an essential tool to facilitate effective market functioning. It supports liquidity, risk management and effective price discovery.’1
Why would someone want to lend shares?
The main benefit of lending shares is that the lender is paid a fee for lending the shares, like an interest payment.
And the added benefit, for that long-term investor, is that the fee can add to their returns.
It is a common practice in the markets, and many investors are already involved in the share-lending market without realising it as most ETFs, mutual funds, and pension funds lend the shares held in the funds.
What rates are available in the market when you lend a share?
Rates that are available through lending shares are not the same as the rates that you might expect on your savings account. This is because the borrowers are having to provide collateral to protect you, the lender. This is a bit like the interest rates that you pay on a mortgage being lower than the rates that you pay on an unsecured bank loan.
Since the loans of the shares are low risk, the rates that are paid are mainly driven by the demand for the share that is being lent. It is fair to say that these rates vary hugely between shares, and can change dramatically over time, sometimes spiking up to over 100%, or more.
If you own shares that are suddenly in demand from borrowers, you may notice the income you receive will increase. It's unlikely that this increase will last for more than a few days or weeks at a time.
Practical matters
How does it work?
The process works like this:
1. Firstly, we let the borrowers know what shares we have available to lend.
2. The borrower decides what they would like to borrow and we let them know how much collateral they need to provide.
3. Once we have confirmed that they have provided the collateral, we transfer the share to the borrower.
4. While the share is on loan, we calculate how much collateral we need on a daily basis. The borrower either sends us more, or we return some to them, depending on how the value of the share has changed that day.
5. When the borrower decides that they want to return the share, or we ask for it back, the reverse happens. They send the share back to us and once we confirm that we have received it, we release the collateral to them.
If you would like a bit more detail on this, there is a section further on below which drills down a bit further.
Whose shares get lent?
We use a proportional basis for US and UK share lending. This means when there is a loan for a given stock, every Freetrade customer will have a proportion of their shares lent based on the weighting relative to other customers. For example, if there is a loan for 100 shares of Amazon and there are 4 customers that hold 50 shares of Amazon, each customer will have 25 of their shares lent out.
Where stocks are in heavy demand, the whole pool of available stocks may be lent out, except for an amount that we keep on hand as a buffer. We keep this buffer to make settlement quicker for customers who want to sell their shares.
What are the risks?
The main risk to consider is that a borrower may be unable to return an equivalent number of shares to the lender when a loan is recalled.
The causes of this failure can include:
1) Market liquidity - shares in a company don’t trade frequently and, therefore, the borrower can’t buy back the shares.
2) Administrative errors - as with any share transaction, settlement is not guaranteed, and loans and returns can fail. With shares being lent and returns being linked to buys, settlement becomes dependent on the next stage in the chain. Lenders and borrowers have processes and controls in place to mitigate this occurring and to resolve instances quickly.
3) Borrower default - a borrower may become insolvent or be unable to pay back its debts, including repurchasing shares that it borrowed.
The main purpose of the collateral that is held is to make a lender whole in cases when a borrower is unable to return shares to the lender.
Since share lending is conducted under a market standard contract, there is recourse for Freetrade if a borrower fails to return shares.
What if I want to vote my shares?
If your shares are on loan, it may not be possible to vote if the opportunity arises. If you want to vote your shares, you can contact customer service to see if it’s possible to recall them.
Remember that we don’t offer shareholder voting on all shares available on our platform.
What if I receive a manufactured dividend?
If shares that you own are on loan and a dividend is paid, you may receive this as a manufactured dividend. This will be the same amount.
If you receive a manufactured dividend, it will be marked in your account statement to help when preparing your tax return.
Depending on your circumstances this may be subject to different tax treatment. The specific circumstances are set out in the Income Tax 2007 legislation (which you can review here) and relate to profits of a trade carried on by the person and the use of double taxation relief.
This is not tax advice and if you think that this might affect you, you should consider consulting with a tax professional.
How do we protect you?
Losses are very rare
Losses for lenders in the securities lending markets are very rare. In fact, in the US, mutual funds have not disclosed any losses due to securities lending to the SEC2 through their regular reports. Similarly, BlackRock3, the biggest fund manager in the world, has only recorded three instances since 1981 when a borrower defaulted on a loan. In all three cases BlackRock was able to repurchase the shares using collateral that they held.
The fact that losses are so rare is because the market is very well organised. It needs to be because virtually all of the lenders in the market have a responsibility to their investors to make sure that they do not suffer losses.
This section sets out how Freetrade protects you when your shares are lent out. Don’t worry if it gets a bit technical in places, the first line of each section tells you what you need to know.
Our first responsibility is to you
You lend your shares to Freetrade, and we then lend them on to our counterparties. Whatever happens, we have the obligation to return your shares to you.
Since you are lending your shares to Freetrade through this process, it is Freetrade who has to return the shares to you. So even if the counterparty we lend the shares to doesn’t return them to us, we would need to buy the shares in the market and return them to you. Freetrade is therefore your first line of protection. As a regulated business, we hold capital to protect customers in these scenarios and, ultimately, the FSCS provides a final backstop for customers.
Selecting the right borrowers
Freetrade only lends your shares to borrowers that we assess to have a high credit quality, and processes in place to monitor them.
A G-SIB, or global systemically important bank, is a bank which is so large and important that its failure could pose a threat to the international financial system. A bank designated as a G-SIB is more closely supervised by regulators and it has to hold more risk-based capital to reduce the likelihood that it gets into difficulties. They are also more likely to be supported by the authorities if a problem emerges. By only lending to these banks, we know that the risk of one of them defaulting is very small.
Collateral
When we lend out your shares, we keep collateral worth at least as much as your shares which we can sell if anything goes wrong.
When we lend out shares, the borrower will have to transfer to us government bonds that are worth at least the same amount as the shares on loan.
Markets move up and down every day and, therefore, we have processes in place to check the value of the collateral that they hold against the value of the shares each day the loan is open.
If the shares have gone up in value, then the borrower will need to transfer more collateral to the lender. If the shares have gone down in value, the lender may need to return any excess collateral to the borrower.
If the borrower doesn’t return an equal number of shares to the lender, then the lender can sell the collateral and use the money to buy shares on the open market, making the lender whole.
If the value of the shares on loan is higher than the collateral that’s held, the borrower is on the hook to pay the difference.
While these situations where a borrower “fails to deliver” shares do occur, they are relatively rare, especially amongst the largest global financial institutions - such as the Global Systemically Important Banks (“G-SIBs”). These are the types of institutions that Freetrade will be lending shares to.
Putting in place the right controls
Freetrade operates strong controls to prevent anything from going wrong.
As well as processes around selecting high-quality borrowers and making sure we have the right amount, and right type of collateral, Freetrade puts in place rigorous controls to make sure that the whole process runs as it should do. There are a lot of these, and they are quite technical, so we have included some more detail in the section below.
FSCS protection
As a final level of protection, Freetrade is covered by the Financial Services Compensation Scheme (“FSCS”).
The FSCS may pay compensation to you if we are unable to return your shares in the event that Freetrade becomes insolvent.
This includes our obligations to you in respect of Share Lending, such as not being able to return your shares to you.
There is a £85,000 limit to the amount that the FSCS may pay to an eligible claimant in respect of investment business with us.
Regulators and the law
Share lending is a highly regulated area of global markets. Regulators take a close interest in this part of the market because these transactions play an important role in making sure that markets function properly.
In the UK, the Financial Conduct Authority is the primary body that oversees share lending. There are rules in place that require hedge funds to disclose short positions when they reach certain thresholds, the FCA sets conduct rules for firms involved in share lending.
Banks that help facilitate these transactions are also subject to oversight by the Prudential Regulation Authority at the Bank of England.
Finally, share lending is subject to a legal framework which, in the UK, is called a Global Master Securities Lending Agreement (GMSLA). This is a standard contract that outlines the terms and conditions that lenders, banks and borrowers must adhere to in order to participate in the market. This includes a number of the protections we’ve outlined above.
In the US, the Securities and Exchange Commission, the SEC, is primarily responsible for oversight of share lending. Much like the FCA, there are rules in the US about transparency and collateral. There’s also something called Regulation SHO that addresses specific issues around short selling, like borrowers failing to deliver shares back to a lender.
In addition to the SEC, there are regulators of brokers (FINRA), as well as the Federal Reserve, that monitor compliance to rules in the share lending market. There’s also a standard legal framework in the US called a Master Securities Loan Agreement (MSLA) that outlines all of the protections and rules governing these transactions.
Learn more
If you are interested in learning more, we have added in some more information here. It gets a little technical in places, but we wanted to make the information available to you, in case you wanted to explore the topic further. We’re always looking for ways to help our customers understand our services better, so if you have a question about securities lending please let our customer services team know through our in-app chat and we’ll aim to answer it.
The lending process
This section describes the lending process in a bit more detail. It covers the same process that is described in the section at the top of the page, but provides a few additional points:
● Freetrade exercises its right of use over the assets from our customer in order to lend them. Using this arrangement, our customers only ever lend their shares directly to Freetrade. This means that they do not have any direct exposure to the borrower, and that it is always Freetrade that is responsible for returning your shares.
● In the UK, the collateral that is provided is held on behalf of our customers at an independent third party firm. In this case, JP Morgan. This means that if anything should happen to the borrower or to Freetrade, the collateral will remain the property of the customer
Our controls
We have in place a range of controls which are designed to ensure that you receive your shares back when you need them. The table below gives some examples and what they are used for.
How can a lender keep track of their shares?
Shares, bonds, and other types of securities that we buy and sell on public markets, just like cash, are “fungible”.
What does that mean?
That’s a way of saying that shares are interchangeable for another of its kind. It doesn’t really matter which one of the 15 billion or so Apple shares you own, so much as it matters that you’re certain you benefit from owning one of them.
When the share price goes up, you’ll benefit. When Apple pays a dividend, you receive that although it may be a manufactured dividend. And when Apple asks you to vote on something, you can cast that vote for your one share.
Companies (via a registrar) maintain a record of who owns their shares. When it comes to buying shares as a retail investor, you’ll typically buy shares through the broker’s “nominee”. Your name won’t appear on the registry, your broker’s nominee will just show that it owns one (or more) shares in the company.
When you want to buy or sell shares, your broker will update their records and execute a transaction on your behalf, exchanging cash for shares or vice versa. That cash and shares are kept safe in client money or custody accounts.
The same goes for when shares are put on loan. Your broker keeps track of the collateral that they hold for you and, if you want to sell your shares, your broker will have to recall an equivalent number of shares (not necessarily the exact same ones) from the borrower to settle the sale.
Other resources
Securities Lending Explained - What you need to know in 5 minutes!
International Securities Lending Association
This is the leading non-profit industry association that represents the interests of participants in the share lending and financing markets across Europe, the Middle East and Africa. There are over 180 member firms (as of 16 August 2024), including some of the largest asset managers in the world and the biggest investment banks.
Blackrock’s introduction to securities lending
Blackrock is the world’s largest asset manager and one of the biggest participants in the securities lending market. Many of Blackrock’s iShares ETFs that are available on Freetrade use securities lending to improve the returns on the funds. Check out the iShares FTSE 100 ETF, for example, which shows that it typically generates a return of between 0.01% and 0.03% per year. Past performance is no guarantee of future results.
The European Central Bank’s primer on share lending
The European Central Bank oversees the functioning of the financial system across many national markets. The ECB has been a lender of securities in certain circumstances in the past. This explainer walks through the process and how it helps markets work.
Investopedia’s explainer on share lending
This is an accessible and engaging overview of share lending, with more of a focus on the US market. It goes into detail about the types of securities that are lent and why they might be loaned out in the first place.
1 - Short Selling Regulation Review - HMT - Government Response - July 2023
2 - https://www.qmul.ac.uk/sef/media/econ/events/PekkaHONKANEN_jmp.pdf
3 - https://www.blackrock.com/uk/professionals/solutions/securities-lending
