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From what I understand, a common business line of brokerages is lending out the shares of their clients while they are sitting idly in their accounts. Average borrow rates of blue-chips are around 0.20%.

I was thinking: given $10M of client assets, why would a broker-dealer not instead open a prime brokerage account with some bank and borrow $5M in cash [over]collateralized against the the $10M in assets, and then buy Treasuries, which would give an effective 1.5% (50% of 3%) return on the assets?

It seems like the only real risk here is the US defaulting on its short-term debt. What am I missing here?

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    Who owns the $10M assets? Sep 10, 2022 at 18:58
  • @ChrisW.Rea The clients, though there may be some technicalities here with respect to ownership versus custody.
    – actinidia
    Sep 10, 2022 at 19:14
  • Side note to my answer - borrow rates on short selling stock is a separate issue from the borrow rates you are talking about here. Simplistically - the number of shares being shorted at any given time is typically some tiny fraction of the total number of shares outstanding. Oversupply of available shares + the low risk to lending them means the rate charged is quite low. Sep 10, 2022 at 21:02
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    Is a brokerage firm legally allowed to borrow against customer securities? Sep 11, 2022 at 19:43

3 Answers 3

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Pause on the issue with 'having security for a loan' for a moment [it seems to be clouding the economic reality of what you are presenting]. Your plan is for a bank to lend your hypothetical broker money. The bank then charges the broker an interest rate. And then the broker... pays for that with a higher interest rate they earn by buying T-Bills?

So why wouldn't the bank just buy the T-Bills?

The point is that the t-bill rate offered by the US government is basically the lowest possible interest rate there is - on the basis of the US government being considered the lowest USD credit risk for possible default.

In order for the t-bill rate to be higher than your broker's charged rate on its loan from the bank, the bank would need to consider your broker to be a lower risk of default than the US government. This doesn't make any sense - it is self-evident that any random brokerage house has a higher risk of bankruptcy than the US government. Your broker has no army, has no ability to raise taxes, has a workforce of maybe a few dozen [or perhaps a few thousand] instead of hundreds of millions, has no recognized rule of law... well, you get the picture.

You say that this debt to the bank is 'very secured' because of the stock assets held by the broker [forget about the fact that the broker does not own those assets, and therefore has no ability to securitize them] - yet surely you can see that the security offered by the US government is greater. Therefore, t-bills should have a lower rate of interest than this private debt, and your plan simply has no value.

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    It's not mainly about having an army or the ability to raise taxes, government bonds are considered risk-free mainly because a govenment never really has to default on domestic debt (bonds in the national currency) - there's always the option of "just printing more money". Some governments may sometimes decide to default on domestic debt, but they're never really forced to (unlike international debt - bonds in other currencies than the national one).
    – TooTea
    Sep 10, 2022 at 21:36
  • This doesn’t seem right. Prime brokers regularly lend to hedge funds—which are substantially riskier businesses than brokerages—at (give or take) 35 bps above OBFR or LIBOR; they manage this risk through margin requirements. Charging over 100 bps above Fed Funds (thereby matching or exceeding the T-Bill rate) would be pretty onerous for institutions seeking leverage, no?
    – actinidia
    Sep 10, 2022 at 22:49
  • @tootea Correct, running a functioning government, collecting taxes, and printing money are all parts of what keeps the credit risk for government securities low. Sep 11, 2022 at 0:55
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    @actindia so if you were correct, and the risk-free rate offered by the government was higher than what would be charged by a bank to private institutions, then why wouldn't the bank just buy those t-bills directly? Sep 11, 2022 at 0:57
  • @Grade'Eh'Bacon Plausible reasons I can think of could be (1) the sum of fees charged to PB clients across lending and the other services cross-sold to institutions exceeds the RFR while still providing value to clients and building relationships with them (these are very important to investment banks); (2) providing these services stimulates growth of [successful] funds, which means more AUM and thus compounds the cashflows from (1); (3) financing the carry trade involves risks, à la @nanoman’s answer
    – actinidia
    Sep 11, 2022 at 5:52
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They don't own the stock

The first big thing is that they are prohibited to do so, they are required by SEC custody rules to keep the stock under a qualified custodian unencumbered. E.g. 17 CFR § 240.15c3-3 Customer protection - reserves and custody of securities, states that it is acceptable if the stocks "(5) Are in the custody or control of a bank as defined in section 3(a)(6) of the Act, the delivery of which securities to the broker or dealer does not require the payment of money or value and the bank having acknowledged in writing that the securities in its custody or control are not subject to any right, charge, security interest, lien or claim of any kind in favor of a bank or any person claiming through the bank", so if they borrow against those securities, they're failing in their custodial duty.

But even if they did want to ignore these rules and attempt doing that, the lenders would not accept it. A lender will accept as collateral something which they can legally take over if the debt is not repaid.

A contract by a broker-dealer which states "I'll hand over my customers' stock" is not enforceable, since they don't own the customers' stock, and they can't hand it over to the lender willingly, and they can't be taken unwillingly since even in insolvency the court won't hand over the customers' stock to whoever has valid claims against the broker-dealer.

So the limiting factor is that no sane, diligent lender will consider it as valid collateral.

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I think you are asking about earning a small spread between an overnight borrowing rate and a longer (but still short-term) Treasury bill rate. That small spread, if it exists, is only a fair compensation for risk. Specifically, the risk is that interest rates rise before maturity, increasing the nightly borrowing cost and slightly reducing the market value of the Treasury bill. Then the choice is potentially to exit the trade at a loss, or to hold the Treasury bill to maturity while continuing to pay the higher borrowing cost, thereby likewise incurring a loss.

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  • This is correct. The real risk is that interest rates will go up. Sep 11, 2022 at 23:17

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