Do you have a margin account with your broker? If so, did you know that the shares you have purchased may be lent out to other parties without your knowledge or granted permission? When opening a margin account, you are essentially giving permission to the brokerage firm to lend out the securities in your account even if you don't realize it.
When your shares are lent out you can lose your voting rights; but on the positive side, lending out your shares can have great benefits. In this article, we will look at what your broker could be doing with your shares as well as potential ways that you could benefit.
How Margin Accounts Work
A margin account is a way to leverage the capital and securities you own to purchase additional investments without having to invest any additional capital. You simply borrow from your broker to buy more securities. The broker will charge you interest on the borrowed money and use all the securities (those already in your margin account and the ones you just bought) as collateral.
Note that the risk of trading on margin is greater than trading in a cash account because you can, in theory, lose more money than you started with in your account.
What Happens to the Securities in Your Margin Account?
The securities in your margin account may be lent out to another party, or used as collateral by the brokerage firm at any time without notice or compensation to you, when there is a debt balance (or negative balance) on the account where you have accessed the margin funds. If the account is in a credit state, where you haven't used the margin funds, the shares can't be lent out.
The borrowers of stocks held in margin accounts are generally active traders, such as hedge funds, who either are trying to short a stock or need to cover a stock loan that has been called in. Investment firms that need an underlying instrument for a derivatives contract might borrow your margined stocks from your broker. The brokerage firm may also pledge the securities as loan collateral.
Additionally, if your margined shares pay a dividend but are lent out, you don't actually receive real dividends because you aren't the official holder. Instead, you receive "payments in lieu of dividends," which don't qualify for the 15% dividend tax rate. However, you will only have to pay the high income-tax rate if the firm clearly states that the dividend income was payment in lieu on the Form 1099-Div - if it isn't stated, you will receive the lower 15% rate.
Back to Cash?
If the above doesn't sound too appetizing to you and you're adamant about retaining your vote and want to avoid a potential dividend tax hassle, the easiest solution is to transfer your shares from a margin account to a cash account. Shares held in a cash account can't be lent out, which removes the voting and dividend issues.
However, if you are willing to give up some of the above and take on the additional fees to access the greater capital in a margin account, you will need to ensure that you keep your account in a credit state around important voting times (as the brokerage firm will need to return the borrowed shares).
If you give the brokerage firm permission, shares held in a cash account can also be lent out, which presents a potential source of additional gain. This process is called share lending.
There can be a lot of demand by short sellers and hedge funds to borrow securities, especially on securities that are typically hard to borrow. Similar to a margin account, when you borrow capital or securities, you are required to pay interest on the amount borrowed.
Depending on market rates and the demand for the securities, the exact amount of interest charged for borrowing securities will vary (the harder to borrow, the higher the interest). The most attractive securities to lend are those that are hardest to borrow for short selling, which usually means small caps or thinly traded stocks as well as shares that are already heavily shorted or have fallen in price.
This demand presents an attractive opportunity for investors with the securities in demand. If you have a cash account with securities in demand, you can let your broker know that you are willing to lend out your shares. If there is demand for these shares, your broker will provide you with a quote on what he/she would be willing to pay you for the ability to lend these shares.
If you accept, your broker will lend your shares out to a short seller or hedge fund for a higher rate and pocket the difference, as well as satisfy another customer's demand and generate commissions. For example, your broker may give you 8% interest on the loaned shares while lending out at 13%. Depending on the size of your position, it can be a nice additional source of return. This method also allows you to keep your existing long position in the security and benefit from its upward movement.
Depending on the broker, he/she may or may not provide this service, and may also require a minimum number of shares or dollar amount.
Investors should always be evaluating everything on a risk/reward basis from the stocks they invest in to the accounts they open. Margin accounts can be attractive as you can generate a large return by using a brokerage's capital. However, there is a greater risk of loss, and investors can also lose voting power.
Alternatively, while a cash account may seem boring as there is no leverage, through the practice of lending securities, investors can increase their returns with another source of income.