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Suppose a hedge fund that's short on a bunch of shares goes bankrupt. As I understand it, shorted shares are borrowed (because naked shorts are illegal) so I'm guessing the lender will lose money just like a bank that made a bad loan.

  • Are brokerages typical lenders of short shares and are they typically liable?

  • Does someone with an account at a brokerage need to consent to letting their shares to be borrowed? Is the consent something in the fine print?

  • Unlike FDIC insurance the broker could owe theoretically infinite money (if no one is selling). How does federal insurance (SIPC?) work for such situations?

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In an over the counter agreement between private parties, the lender is at risk.

For traditional shorting done on exchanges, the lending broker is at risk and is liable. Regulations exist to protect the parties involved but they are not infallible (margin requirements, etc.).

Shares in a cash account cannot be loaned out whereas shares in a margin account can be loaned out (the fine print) unless you sign a do not lend shares agreement. When you open a margin account, you sign a hypothecation agreement and sometimes a rehypothecation agreement where the broker can use your shares as collateral for his own loans and trading. Again, regulations exist to protect the parties involved but they are not infallible (for example, a limit of 140% on rehypothecation).

Share lenders (account holders) tend to have no clue that their shares are being loaned out unless their broker is sharing a portion of the borrow fee with them.

SIPC insurance covers the custodial function of a brokerage firm as well as as protection against unauthorized trading or account theft. It provides up to $500,000 in total coverage per customer for lost or missing assets of cash and/or securities. It covers up to $250k of cash. It does not protect one against loss of security value for their own bad decision making.

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  • Does "SIPC insurance covers the custodial function of a brokerage firm" cover the brokerage going bankrupt because #1 too many shorters went bankrupt, #2 leading to the brokerage going bankrupt because they ran out of money to put back the borrowed shares?
    – RonJohn
    Jan 29, 2021 at 17:37
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    The SEC's Customer Protection Rule requires broker-dealers to segregate customer securities and cash from the broker-dealer’s market activities. SIPC protects the innocent bystanders such as the average Joe with a cash account at the bankrupt firm and the share lenders as well. Because of the magnitude of the GME short squeeze, several brokers have already begun imposing restrictions on GME trading in order to protect themselves. Jan 29, 2021 at 18:10
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    Thanks Bob. The "TLDR" I got from this is brokerages are often the lenders, only people with margin accounts need to be concerned about loosing their shares, and in general people are only insured against fraud.
    – philn
    Jan 29, 2021 at 18:28
  • @BobBaerker wouldn't those brokers be vulnerable to other brokers' clients buying GME anyway?
    – user253751
    Jan 29, 2021 at 18:36
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    @BobBaerker do they not lose their shares even if the borrower defaults? or the borrower and then the broker?
    – user253751
    Jan 29, 2021 at 20:30

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