Fully paid securities lending: How it works, benefits and risks

When you invest in a stock , you typically expect to make returns in one or two ways: through dividends and/or profit from appreciation when you sell. But whether you’re a long-term investor or seeking extra income in the short-term, you can enhance your portfolio with another option: fully paid securities lending through a fully paid lending program.

What is fully paid securities lending? Securities lending is a practice where you lend a stock or other security to a financial institution. It’s a strategy that can be used by both individual and institutional investors to enhance the revenue on your portfolio by allowing you to potentially earn income on securities that would otherwise sit idle.

In a securities lending program, the borrower (a financial institution like a bank or brokerage firm) will review your portfolio to determine which securities are eligible for borrowing. This is automatic, and your securities may be loaned out at any time — but you don’t have to choose which ones or when. The borrower makes the decision.

Keep in mind, though, if you’re participating in a lending program there’s no guarantee your securities will be borrowed (we’ll explain why later on).

When a security is loaned, the borrower must provide collateral for the loan in the form of the security’s cash value — this gives the investor protection in case the borrower defaults. So, while you’ll still see your security listed in your account, it will be replaced by cash for the duration of the loan.

To participate in securities lending, like Ally Invest’s Securities Income Program, all you need to do is consent to enroll. Once you’re eligible, we’ll see if any of your securities are in demand. If so, they’ll be automatically lent out in exchange for interest. After you give your consent to enroll, we’ll auto-enroll you the moment you become eligible .

We’ll identify your in-demand securities and loan those out to other investors. While they’re borrowed, they’ll accrue a daily interest. The interest rate is determined based on the demand in the lending market and value of the security.

You’ll see borrowed shares and earned interest in your account activity in the middle of each month and in your end-of-month account statement. You’ll also see the value of any dividends as they’re earned.

Even if we’re borrowing your shares, you can sell as normal with no restrictions. We’ll simply end the borrowing agreement for shares you choose to sell.

What about taxes ? How can self-directed traders manage the tax implications ?

You do not receive dividend payments for the stocks on loan. Instead, you will receive a payment in lieu equal to the value of dividends paid on loaned shares. They will be taxed at your marginal tax rate instead of the prevailing dividend tax rate.

Dividend income, or income you receive when a company offers dividends for holding shares, is taxed at a different (usually lower) rate than the marginal tax rate. Consider consulting with your tax advisor before enrolling in a securities lending program if you have concerns.

Participation in a fully paid securities lending program is generally hassle-free and won’t cost you any fees. But, as always when it comes to investing, it’s important to be aware of any potential drawbacks.

Typically, if you loan out a dividend-paying security, you’ll receive cash in lieu of your regular dividend payment.

When your shares are lent out, you also forfeit your proxy voting rights to the borrower. While this probably won’t be a big deal to most retail investors, it may be more of a concern to larger institutional investors.

The good news is that even when your shares are borrowed, you can still sell them at any time. The collateral will be returned to the borrower, and you’ll receive the proceeds from your sale as you usually would. It's important to note that shares on loan aren't covered under Securities Investor Protection Corporation (SIPC) — counterparty default is a risk. Ally provides collateral at 100% of the loan value.

As we mentioned earlier, even if you enroll your self-directed trading account in a securities lending program, your shares won’t necessarily be borrowed. Financial institutions borrow securities for a variety of reasons, often related to trading strategies like facilitating short sales. Typically, the securities that are borrowed are those that are harder to borrow due to a high demand and limited supply.

Itching to ramp up your investment returns? If you’re sitting on stock or ETF securities that you aren’t actively trading, fully paid securities lending could be an investment strategy to consider. It could add extra income to your portfolio with virtually no effort on your part.

In addition to providing extra returns to investors who lend securities, securities lending also helps financial markets with liquidity. Liquidity means how much an asset can be bought and sold quickly and at a stable price, which often depends on the number of buyers and sellers present and whether transactions can take place easily.

The main benefit of securities lending for investors is that it can help them to potentially generate additional income on securities they already own. There is also no cost to participate in these programs and it's also easy to get started.

When you first learn how to get started investing , this may be an avenue you've never considered before. Before you decide whether fully paid securities fit your needs, consider the risks and benefits first before moving forward with this option.