You may have noticed a few investment platforms have started offering investors the option to loan their shares and earn so-called passive income. An opportunity to make money from something you already own. You just have to click a box to agree and the platform deals with all the legwork. But is this really a good idea? After all, there’s not usually a free lunch available in financial markets.

Dictum Meum Pactum* – my word is my bond

My initial reaction was caution and scepticism. There must be downsides, and reading some terms and conditions revealed a few details worth being aware of.

Firstly, who is borrowing my shares and can I trust them? The borrowers are described as “high quality”, but who are they and how is this status determined? In my mind this was going to be a combination of individuals and institutional investors, and on that basis I’m actually not sure which group I trust less.

In fact, and in hindsight unsurprisingly, it’s investment banks. We can all feel safe in the knowledge that they have our best interests in mind, wouldn’t do anything reckless, and if something went wrong they would nobly bear responsibility and accept the consequences…

Given my distrust of these particular borrowers, I was hoping for some better backup options. So it was good to read that the investment platform provider promises that if the borrower fails to return the shares they will sell collateral and make up any shortfall.

This is reassuring, but what happens if the market (perhaps all markets including the bond market, which are increasingly closely correlated) undergoes a correction and the collateral becomes less valuable than originally supposed?

Why would these investment banks borrow shares? It’s not something that ever occurred to me to do, and I had always assumed it was for short-selling. If that’s the case do I want to encourage this behaviour, especially in shares that I own? The near-term payback of a small and uncertain income doesn’t seem to outweigh the downside of the stock I’m lending becoming thought of as short-worthy and then this facilitating its fall.

It’s not quite as clear-cut as that however. Borrowed shares can be used for short selling, but an apparently more typical (and reassuringly mundane) use is to help smooth out transactions in markets, like helping investors meet settlement deadlines and improving liquidity, which is good for everyone.

A matter of collateral

Borrowers of the shares transfer collateral in the form of, for example, government bonds, with a value in excess of the value of the shares being loaned. Borrowers then pay a fee which increases with increasing demand for the underlying shares. It would be interesting to know how this is defined or calculated, or at least to see the stats on historically what form this has taken.

Collateral is held in line with the FCA client asset rules, which means these assets are held separately to protect them from the issuer failing, but this of course doesn’t stop the value of the bonds from falling in value.

The collateral is worth at least 105% of the value of the shares being borrowed. This is fine, but there’s still the risk of the collateral used being illiquid and not well correlated with the shares they are held against. This is mostly mitigated if the collateral is government bonds, as these are considered to be about as risk-free and liquid as you can get.

The FSCS protection also still applies, so that’s some consolation depending on the size of your portfolio being loaned, but it’s really a last resort.

The investment platforms would also make up any difference if the collateral was insufficient to cover it. This seems to imply that if the investment platform were to become insolvent, the value of the shares would be lost if the rest of the protections in place fail for some reason.

If there is a big failure, it would likely take a long time before the assets were sold and their value realised in order to buy back the loaned shares, which would be a hassle, though there would likely be bigger things to worry about in the markets if it had come to that. Overall the risk does seem to be low.

Tax

Tax calculations can be a miserable task at the best of times. I’m sure most investors don’t want to complicate it more than HMRC already do. The small print and terms and conditions state that any dividends will be paid to you as a manufactured dividend.

Is this now not a dividend in the eyes of the tax authorities and so treated as some other form of income, taxable at a potentially higher rate? Artificial manufactured dividends may be more complexity than I’m willing to embrace in my tax returns, unless there’s a significant upside benefit.

Other considerations

When your shares are on loan you transfer your right to vote in shareholder meetings. Not a big deal for many investors perhaps, but being able to vote is an important right that we should be exercising. By loaning your shares you’re giving your vote to institutional investors, and they have a lot of power already.

What if the market rallies or crashes? How does that affect the behaviour of the investment banks borrowing your shares? Will this share lending encourage behaviour that chases shares that are more in demand, creating bubbles and influencing markets in unintended ways unlinked to any underlying fundamental analysis reasons.

I’m aware of course that our shares are likely being lent out all the time anyway by the large pension funds and large institutional investors who manage our funds, and we’re likely not cut into those deals. This new option at least gives smaller investors a way into this market.

How good are the returns?

If all of that hasn’t put you off the idea of lending your shares, what you’re probably most interested in is how much you can earn. This therefore may come as a disappointment, but it seems to vary daily and depending on the share in question, and maybe even with the quantity of shares being lent.

Most yield between 0% and 0.5% per year, but can in a very small number of cases be up to 10%. There’s a bit of a marketing tactic to get you thinking there’s big (or at least easy) money to be made here and it’s simply a case of ticking the box to lend your shares out.

However, it’s not as lucrative as it may at first appear. For a start, you wouldn’t be taking the first slice of the pie. The provider takes 50% of the income. It’s important to remember someone is making a decent return before it even gets to your cut (I’m thinking again of the investment banks). It’s down to the individual to decide if the risk premium here is enough to justify the risk.

In most cases there is unlikely to be much risk, given how few of the shares at any given time will be in demand, and I suspect that smaller investors (who will make up the majority of the user base by account numbers if not by assets under management) will not have much in individual shares to endanger their portfolio, as long as they’re properly diversifying as I wrote about in another post.

So it’s not highly (or even moderately) profitable, comes with some risks, potentially contributes to hyping up reactionary market behaviour, can accelerate the downside movements, is probably only available for the sorts of shares I wouldn’t be interested in buying individually anyway, and could cause annoying tax complications. I am of course always open to being proved wrong and having my mind changed, but I’ll skip this one for now, thanks.

* The motto of the London Stock Exchange