The Downsides of Stock Lending

Stock-lending has been a capability of brokerages for as long as I can remember. But recently I’ve seen popular brokerages offer retail investors the option to participate in stock lending, such as Interactive Brokers and Wealthsimple. The idea of stock lending is pretty simple: you lend out your shares to short sellers in exchange for income. The brokerage takes a cut to facilitate the lending. You can make more income based on the popularity of your holdings. ETFs and low-volatility stocks are unlikely to produce income. Wealthsimple even has a diagram showing how meme stocks can generate a lot of income.

Getting extra income for stock lending seems like a no-brainer. But what’s the catch?

No SIPC/CIPF Coverage

All of the holdings in your brokerage account are insured up to a certain amount. In the US, you’re protected by the Securities Investor Protection Corporation (SIPC) up to US$500k. In Canada, you’re protected by the Canadian Investor Protection Fund (CIPF) up to C$1M. When you lend out your shares, you no longer have protection for those shares. That means that if the borrower goes bankrupt and doesn’t return your shares, you’re out of luck. Additionally, if your brokerage goes bankrupt, your loaned shares are not protected.

Although it is unlikely that you will not receive your shares back, this is a big potential risk. Shares are generally loaned out for shorting and we remember what happened to Melvin Capital with Gamestop.

Helping Short Sellers

As I mentioned already, the primary purpose for borrowing shares is to short a stock. So by loaning your shares, you’re helping short sellers.

Unfavorable Tax Treatment of Dividends

If you loan out your dividend-paying stocks, you still receive a payment in lieu of dividends. You receive a cash distribution instead of a more favorable qualified dividend. In a margin/taxable/non-registered account, that means that your “dividends” are taxed as ordinary income and are ineligible for a lower dividend income tax rate.

Waiver of Voting Rights

This one doesn’t matter as much because retail investors don’t have enough shares to affect voting results. Additionally, if you’re like me, you rarely vote.

Limited Access to Loaned Shares

You have no guarantee that the borrower can return your shares promptly. That means that you might not be able to transfer shares between brokerages.

Conclusion

I read on both Blossom and Reddit about retail investors signing up for their brokerage’s stock lending program because they want the extra income, but I don’t think they considered what that means. I recently transferred my US shares to Interactive Brokers and plan to transfer my Canadian shares to Wealthsimple next year. However, I will not participate in a stock lending program. As someone who receives half of my dividends from non-registered accounts, I don’t want to pay a higher amount of tax. Additionally, I don’t want to risk not receiving my shares back.