A short sale is a common type of trade in the financial world. It involves selling an asset that a trader does not own, therefore, has to borrow and then buy back and return at a later date. The investment philosophy is that the borrowed asset will decline in price and the investor will earn a profit by selling at a higher price and buying back at the lower price. Selling short is done on margin and is a risky endeavor due to the unlimited potential loss.
In determining who benefits from loaning shares in a short sale, 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.
Benefits From Loaning Shares
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 to. 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 and not the individual investor. So, any benefit received (along with any risk) belongs to the broker.
The broker does receive an amount of interest for lending out the shares and 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 they 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.
In the event that the lender of the shares wishes to sell the stock, the short seller is generally not affected. The brokerage firm that loaned out the shares from one client's account to a short seller will usually replace the shares from its existing inventory. The shares are sold and the lender receives the proceeds of the sale into their account. The brokerage firm is still owed the shares by the short seller.
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 their shares lent out to other parties.
The Bottom Line
Short selling is a risky trade but can be profitable if executed correctly with the right information backing the trade. In a short sale transaction, a broker holding the shares is typically the one that benefits the most, as they can charge interest and commission on loaning out the shares in their inventory. The actual owner of the shares does not benefit due to stipulations set forth in the margin account agreement.