Freetrade rolls out share lending feature: What is it and how does it work?

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Freetrade will allow its customers to loan out their in-demand shares to borrowers in exchange for a small fee, This Is Money can reveal.

Share lending, which is a bit like renting out your stocks, is typically used by financial institutions for trading activities and hedging risk.

Some DIY investment platforms like Trading 212 offer it to their customers, and it is particularly popular in the US.

However, lending stocks comes with risks and is often used to short sell the shares that have been borrowed, which can put downward pressure on their price.

We explain how stock lending works, why people borrow and lend shares and some of the risks attached.

Stock lending: Freetrade customers can lend in-demand shares and earn a fee

How does share lending work?

Share lending, also known as securities lending, is when shareholders temporarily transfer their shares to a borrower in exchange for a fee.

Usually, lenders tend to be ETFs, pension funds and insurance companies while the borrowers are from banks, hedge funds or brokers looking to short-sell shares or support settlement.

In this case, the lender will be Freetrade customers. They can opt in to have their shares matched with a 'high quality' borrower, which will include global investment banks. 

All shares, investment trusts and ETFs in GIAs and SIPPs are eligible, but not those held in an Isa. The platform also says it won't lend out any ETFs which the fund managers rate as being low risk.

When there is demand, shares will be transferred and the borrower will pay a fee. This will typically depend on how much demand there is for that particular share.

Customers will keep half of the fees earned when shares on loan, with the other half retained by Freetrade and their partner running the programme.

Freetrade says that no changes will be made to how customers can manage their portfolio and customers can still sell shares that are on loan as normal.

However, if your shares are on loan it might not be possible to vote if the opportunity arises and you may need to recall them.

Why do people lend and borrow shares?

Investors can make some income from lending their shares, but this will depend entirely on the rates that borrowers are willing to pay and the number of shares on loan.

This will vary from day to day depending on the demand for the shares you earn and the platform says that on a typical day, most shares aren't on loan.

While Freetrade says that customers can make passive income through share lending, the returns are minimal.  

Their conservative estimate shows that if you lent £1,000 in shares, the monthly rate of 0.02 per cent would return a gross monthly income of 20p, meaning a customer would take home 10p a month.

However, in-demand shares could pay even higher annualised rates which could help to offset monthly subscription rates, depending on what shares are held.  

Monthly income: Freetrade says customers can supplement their income through lending

Viktor Nebehaj, CEO of Freetrade, says: 'Our share lending programme opens up a new source of passive income for our customers to grow their wealth over the long term that was previously not widely available in the UK market.

'This income can enhance the returns on their portfolio over time. Retail investors now have the opportunity to participate in such programmes if they believe it will help them to reach their long-term financial goals and if it fits with their risk appetite.'

However, borrowers often borrow shares to short sell the same shares, causing downward pressure on the price. 

How are investors protected and what are the risks?

Freetrade says 'losses for lenders in the securities lending markets are very rare'.

In order to protect lenders, the borrower will send collateral so if they don't return the shares, Freetrade will sell the collateral and repurchase the shares.

Freetrade says it only accepts Government bonds as collateral because they are lower risk and are easy to sell quickly to buy replacement shares as quickly as possible.

It also ensures that the collateral is worth at least 105 per cent of the value of the lent shares.

If the collateral fails to cover the amount, Freetrade says it will make up the difference.

'As a regulated business, we hold capital to protect customers in these scenarios and, ultimately, the FSCS provides a final backstop for customers,' it says.

Share lending is regulated by the Financial Conduct Authority, with rules in place requiring hedge funds to disclose short positions when they reach certain thresholds.

However, share lending does not come without its risks, the main one being that the borrower not returning the shares when it is recalled.

This can be because of market liquidity meaning the borrower can't buy back the shares, or a borrower becoming insolvent and unable to pay back the debt.

It can also simply be a result of administrative error.

Freetrade says: 'With shares being lent and returns being linked to buys, settlement becomes dependent on the next stage in the chain.

'Lenders and borrowers have processes and controls in place to mitigate this occurring and to resolve instances quickly.'