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I'm curious how the person lending shares protects themselves from the downside if the short sellers are correct.

Are they actually loaning shares or is it like the banks, loaning out more money than they actually have knowing that they probably won't ever need all of it at once.

  • what do you mean by "protect themselves"? Shorted shares even if they are yours is done without your knowledge. When you want to close your position, those shares will magically reappear again. – NuWin Apr 4 '16 at 2:26
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Lending of shares happens in the background. Those who have lent them out are not aware that they have been lent out, nor when they are returned. The borrowers have to pay any dividends to the lenders and in the end the borrowers get their stock back.

If you read the fine print on the account agreement for a margin account, you will see that you have given the brokerage the permission to silently loan your stocks out. Since the lending has no financial impact on your portfolio, there's no particular reason to know and no particular protection required.

Actually, brokers typically don't bother going through the work of finding an actual stock to borrow. As long as lots of their customers have stocks to lend and not that many people have sold short, they just assume there is no problem and keep track of how many are long and short without designating which stocks are borrowed from whom.

When a stock becomes hard to borrow because of liquidity issues or because many people are shorting it, the brokerage will actually start locating individual shares to borrow, which is a more time-consuming and costly procedure. Usually this involves the short seller actually talking to the broker on the phone rather than just clicking "sell."

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It is true, as farnsy noted, that you generally do not know when stock that you're holding has been loaned by your broker to someone for a short sale, that you generally consent to that when you sign up somewhere in the small print, and that the person who borrows has to make repay and dividends. The broker is on the hook to make sure that your stock is available for you to sell when you want, so there's limited risk there.

There are some risks to having your stock loaned though. The main one is that you don't actually get the dividend. Formally, you get a "Substitute Payment in Lieu of Dividends." The payment in lieu will be taxed differently. Whereas qualified dividends get reported on Form 1099-DIV and get special tax treatment, substitute payments get reported on Form 1099-MISC. (Box 8 is just for this purpose.) Substitute payments get taxed as regular income, not at the preferred rate for dividends.

The broker may or may not give you additional money beyond the dividend to compensate you for the extra tax.

Whether or not this tax difference matters, depends on how much you're getting in dividends, your tax bracket, and to some extent your general perspective.

If you want to vote your shares and exercise your ownership rights, then there are also some risks. The company only issues ballots for the number of shares issued by them. On the broker's books, however, the short sale may result in more long positions than there are total shares of stock. Financially the "extra" longs are offset by shorts, but for voting this does not balance. (I'm unclear how this is resolved - I've read that the the brokers essentially depend on shareholder apathy, but I'd guess there's more to it than that.)

If you want to prevent your broker from loaning out your shares, you have some options:

  1. Some brokers may let you opt-out in writing. (This may include options like having the shares re-registered in your name instead of being held in "street name.")
  2. If you have a cash account rather than a margin account, your broker is prohibited from loaning your stock.
  3. I've heard but not confirmed that if you have a good-til-canceled (GTC) order on, then your stock cannot be loaned. If true, you could put such an order in at a price far from the market price if you want to prevent the loan.

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