Other tax rules on corporate finance: stock loans: what are stock loans?
Introduction to stock lending
Stock lending is an important mechanism in the efficient operation of the financial markets that enables market makers and other securities dealers to obtain securities (shares and loan securities) to meet deliveries on sales of those securities. For instance, a market maker who is obliged to deliver securities on demand will borrow stock if it has insufficient stock of its own to meet the delivery. Dealers borrow securities to settle ‘short’ sales (selling securities they do not own), and hope to profit by buying equivalent securities at a lower price to return to the lender when the loan matures.
The lender has the right to have the `borrowed’ stock replaced at a future date with securities of the same kind and amount, and will normally:
- receive payments (known as manufactured payments - CFM74300) equivalent to any dividends, interest or other rights that have arisen on the securities in the meantime.
- receive a fee for `lending’ the security. The fee will normally be calculated at an annual rate and will be based on the value of the securities borrowed. The amount of the fee will also depend on the demand for borrowing the particular securities at the time.
- require collateral (CFM74120) from the borrower, either in the form of cash or other securities.
Types of lenders
Lenders are generally UK or overseas institutions such as banks, insurance companies, other financial concerns, pension funds and charities, which hold large portfolios of securities. However, there is nothing to prevent other persons holding securities from entering into stock lending transactions.
Stock lending mostly takes place under a standard form of contract, the Global Master Securities Lending Agreement, which is produced by the International Securities Lending Association (ISLA). This sets out the normal terms for collateral, margin and manufactured payments, though the parties will normally adapt these for particular transactions.
Form of stock loan contracts
The transfers under a stock lending agreement are not sales, but, despite their name, they are not loans. Full beneficial and legal ownership is transferred, so that if the borrower wishes it can on-lend the securities or sell them, purchasing replacement securities at a later date to fulfil its obligation to return equivalent securities when the stock loan matures.
Whilst the lender gives up legal and beneficial ownership of the underlying securities, it retains all the risks and benefits of movements in the price of the securities and will continue to recognise them in its accounts. If the borrower retains the securities it will have no such exposure since its obligation to return equivalent stock will cancel any gain or loss while the securities are in its possession. In practice the borrower may sell the securities in which case it will have a reverse exposure to that of the lender: if it sells high it may later be able to buy back low.