To answer this question, 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 being lent to the borrower, they will receive some benefit, but this is not the case.

When a trader wishes to take a short position, he or she borrows 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 being held in the broker's inventory, or even from another brokerage firm. It is important to note that, once the transaction has been placed, the broker is the party doing the lending. So, any benefit received (along with any risk) belongs to the broker.

As your question suggests, the broker does receive an amount of interest for lending out the shares, and it 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 he or she borrowed, the broker is responsible for returning the borrowed shares. While 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.

The main reason why the brokerage, and not the individual holding the shares, receives the benefits of loaning 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 his or her shares lent out to other parties. (For further reading, see the Short Selling Tutorial and the Margin Trading Tutorial.)

comments powered by Disqus
Trading Center