A:

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.)

RELATED FAQS
  1. How long can a trader keep a short position?

    Learn whether there are any limitations on how long may an investor hold a short position, and explore the costs associated ... Read Answer >>
  2. When short selling a stock, how long does a short seller have before covering?

    There are no general rules regarding how long a short sale can last before being closed out. A short sale is a transaction ... Read Answer >>
  3. How is it possible to trade on a stock you don't own, as is done in short selling?

    Understand how the process of short selling allows a person to sell a stock he or she doesn't technically own by borrowing ... Read Answer >>
  4. How long can you short sell for?

    When an investor or trader enters a short position, he or she does so with the intention of profiting from falling prices. ... Read Answer >>
  5. Can you short sell stocks that are trading below $5? My broker says that I can't.

    Short selling can be very risky for both the investor and the broker. Brokers will often tell investors that only stocks ... Read Answer >>
Related Articles
  1. Investing

    Picking Your First Broker

    If you're a rookie investor, your first big investment decision should be an informed one. Read about how to choose your first broker here.
  2. Trading

    Is Your Forex Broker A Scam?

    While the forex market is slowly becoming more regulated, there are many unscrupulous brokers who should not be in business.
  3. Financial Advisor

    Evaluating Your Stock Broker

    Make sure you're getting the best service by staying informed and involved.
  4. Financial Advisor

    How Brokerage Fees Work

    What you need to know about fees when choosing between a full service and discount broker.
  5. Investing

    What Does a Broker Do?

    In the investment world, broker is a term used to refer to an individual or entity that helps facilitate trading in financial securities.
  6. Investing

    Why Use a Discount Broker?

    A discount broker is a stockbroker that does not offer clients investment advice, but trades shares for a smaller commission than a full-service broker.
  7. Insurance

    Brokers: Do You Want To Sell Stocks Or Insurance?

    Know the difference between working as a broker or an insurance rep.
  8. Trading

    The Best Low-Cost, Web-Based Trading Brokers

    With this table, investors can differentiate between top low-cost, web-based trading brokers by price, capabilities, and offerings.
RELATED TERMS
  1. Give Up

    A procedure in securities or commodities trading where the executing ...
  2. Active Box

    A physical location in a brokerage where securities are kept. ...
  3. Call Money Rate

    The interest rate on a type of short-term loan that banks give ...
  4. Mortgage Broker

    An intermediary who brings mortgage borrowers and mortgage lenders ...
  5. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  6. Buying On Margin

    The purchase of an asset by paying the margin and borrowing the ...
Hot Definitions
  1. Current Assets

    A balance sheet account that represents the value of all assets that can reasonably expected to be converted into cash within ...
  2. Tax Liability

    The total amount of tax that an entity is legally obligated to pay to an authority as the result of the occurrence of a taxable ...
  3. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  4. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  5. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  6. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
Trading Center