A short sale is a common type of trade in the financial world. It involves selling an asset that a trader does not own. The trader borrows the asset, then—by a specified later date—buys it back and returns it to the asset's owner. The investment philosophy is that the borrowed asset will decline in price and the investor will earn a profit by selling at a higher price and buying back at the lower price. Selling short is done on margin and is a risky endeavor due to its unlimited potential for loss.
In determining who benefits from lending shares in a short sale, we first need to clarify who is doing the lending in a short sale transaction. Many individual investors think that—because their shares are the ones lent to the borrower—they will receive some benefit, but this is not the case.
Benefits From Lending Shares
When a trader wishes to take a short position, they borrow the shares from a broker without knowing where the shares come from or to whom they belong. The borrowed shares may be coming out of another trader's margin account, out of the shares held in the broker's inventory, or even from another brokerage firm. It is important to note that when the transaction has been placed, the broker is the party doing the lending, not the individual investor. So, any benefit received (along with any risk) belongs to the broker.
The broker does receive an amount of interest for lending out the shares and is also paid a commission for providing this service. In the event that the short seller is unable (due to a bankruptcy, for example) to return the shares they borrowed, the broker is responsible for returning the borrowed shares. Though this is not a huge risk to the broker due to margin requirements, the risk of loss is still there, and this is why the broker receives the interest on the loan.
In the event that the lender of the shares wishes to sell the stock, the short seller is generally not affected. The brokerage firm that lent the shares from one client's account to a short seller will usually replace the shares fromits existing inventory. The shares are sold and the lender receives the proceeds of the sale into their account. The brokerage firm is still owed the shares by the short seller.
The main reason why the brokerage—not the individual holding the shares—receives the benefits of lending shares in a short sale transaction can be found in the terms of the margin account agreement. When a client opens a margin account, there is usually a clause in the contract that states that the broker is authorized to lend—either to itself or to others—any securities held by the client. By signing this agreement, the client forgoes any future benefit of having their shares lent out to other parties.
The Bottom Line
Short selling is a risky trade but can be profitable if executed correctly with the right information backing the trade. In a short sale transaction, a broker holding the shares is typically the one that benefits the most, because they can charge interest and commission on lending out the shares in their inventory. The actual owner of the shares does not benefit due to stipulations set forth in the margin account agreement.
FAQs
In a short sale transaction, a broker holding the shares is typically the one that benefits the most, because they can charge interest and commission on lending out the shares in their inventory. The actual owner of the shares does not benefit due to stipulations set forth in the margin account agreement.
Who benefits from lending shares in a short sale? ›
The Lenders of Short-Sale Shares
One use of margin accounts includes lending them for short sales activity. When shorting, the seller borrows the shares to be sold. The lender then receives a rebate from the borrower of the shares, who pays a fee.
Why do people lend shares to short sellers? ›
In order to profit from the potential discrepancy between the two prices, short sellers must first find shares to borrow—which is where securities lending comes in. Such programs allow individual clients to lend in-demand stocks to their broker, who then lends the shares to short sellers, with interest.
Who do you borrow shares from when shorting? ›
Short selling a stock is when a trader borrows shares from a broker and immediately sells them with the expectation that the share price will fall shortly after. If it does, the trader can buy the shares back at the lower price, return them to the broker, and keep the difference, minus any loan interest, as profit.
Who benefits from stock lending? ›
Securities lending involves the owner of shares or bonds transferring them temporarily to a borrower. In return, the borrower transfers other shares, bonds or cash to the lender as collateral and pays a borrowing fee. Securities lending can, therefore, be used to incrementally increase fund returns for investors.
What are the benefits of a short sale? ›
The seller avoids foreclosure and is released from some or all of the mortgage obligation with the lender. The seller can get financing approval on another home more quickly after a short sale than foreclosure, and the credit rating recovery is faster according to mortgage lender Quicken Loans.
How do brokers benefit from short selling? ›
Short selling is a risky trade but can be profitable if executed correctly with the right information backing the trade. In a short sale transaction, a broker holding the shares is typically the one that benefits the most, because they can charge interest and commission on lending out the shares in their inventory.
How do I stop short sellers from borrowing my shares? ›
Brokers lend the shares from margin accounts, so one way a small investor can stop the practice is by placing their shares in a cash account instead, Trump Media said in the statement.
Is share lending a good idea? ›
For shareholders, stock lending offers a relatively low-risk way to earn extra returns on the stocks you already own. You maintain ownership of your stocks the whole time. If loaned stocks go up in value, those returns are still yours. If you decide to sell your stocks while they're loaned out, you can.
Can my broker lend out my shares to short sellers without asking? ›
The only case where your broker might lend your securities without your knowledge is when you have a margin account and you are actually borrowing money. > brokers cannot lend your shares without a written agreement allowing it.
Risks and downsides
While stocks are on loan, they are not covered by the federal insurance program that protects investors against the failure of their brokerage. If nobody borrows your shares, you earn no additional income. You could lose principal if the borrower becomes insolvent.
Who loses in short selling? ›
When an investor “shorts” a stock or other security, they're speculating that its value will go down. If that happens, they can purchase the stock at a reduced price and generate a profit. But if the price goes up and the investor later purchases the security at a higher price, they'll lose money.
Can you short sell without borrowing? ›
Naked short selling is a high-risk and ethically dubious financial practice where an investor sells a security, often shares of stock, without first borrowing the asset or ensuring its availability for borrowing. The process involves selling shares one does not own and later buying them back to cover the position.
Why lend shares to short sellers? ›
Stocks in short supply and high demand tend to generate more earnings for the lender since they're more likely to be borrowed, he says. "The direct return is the lending fee, usually expressed as an annualized percentage of the borrowed shares' value," he says.
How to get rid of a short stock? ›
Buy the stock and close the position: When you're ready to close the position, buy the stock just as you would if you were going long. This will automatically close out the negative short position. The difference in your sell and buy prices is your profit (or loss).
What is the point of lending stocks? ›
Stock lending is the lending of shares to another party for a fee as well as with interest charges. Stock lending is primarily done in short-sell trades where the seller doesn't own the stock but needs it for the trade. It can also be used for hedging and arbitrage trades.
Who buys short selling shares? ›
Short Selling occurs when an investor sells all the shares that he does not own at the time of a trade. In short, a trader buys shares from the owner with the help of brokerage and sells them at a current market price with the hope that prices will surge.
What is the downside of stock lending? ›
With stock lending, there is a small risk that a borrower could go bankrupt — maybe the asset they borrow from you increases so much in price that they can't afford to buy it back and return it to you.
