Stock Lending and Short Sales

Short-sale delivery depends on securities being available to borrow. Stock lending provides that operational link.

How Does a Stock Loan Support Delivery?

• Stock loan: Temporary lending of securities so a borrower can make delivery, including delivery on a short sale.
• Securities lender: The party that provides securities and retains the right to receive equivalent securities back.
• Securities borrower: The party that receives borrowed securities and must return equivalent securities to the lender.
• Collateral protects the lender against the borrower's obligation to return equivalent securities.

Lender provides securities → borrower delivers securities → borrower returns equivalent securities. Collateral protects the lender during the loan.

Stock loans also require these operational controls:

• A member acting as agent discloses that capacity to the other parties.
• Before lending to or borrowing from a nonmember, a member determines whether the counterparty acts as principal or agent.
• When a counterparty acts as agent, the member keeps records for the agent, each principal, and each transaction.
• A securities-loan agreement between members gives each member the right to liquidate after specified financial-distress events.
• A loan or borrow with a nonmember requires a written agreement that gives the member a contractual liquidation right after those events.
• Before first borrowing a customer's fully paid or excess margin securities, a member provides written notice about the risks and financial impact of the loan. The notice includes the member's right to liquidate the borrow transaction.

Which Controls Apply Before a Short Sale?

• Short sale: A sale of a security the seller does not own, or a sale completed by delivering securities borrowed by, or for the account of, the seller.
• Locate requirement: Unless an exception applies, before accepting or effecting an equity short sale, the firm must have borrowed the security, entered into a bona fide arrangement to borrow it, or have reasonable grounds to believe it can be borrowed for timely delivery. The firm must document compliance.
• The locate supports the ability to borrow securities for delivery and is intended to prevent an avoidable failure to deliver.

Exam Tip: Gotchas

• Borrowing specified customer securities requires advance written notice. Before first borrowing a customer's fully paid or excess margin securities, a member discloses the loan's risks and financial impact, including its liquidation right.
• A locate requires a borrowing basis and documented compliance. Unless an exception applies, the firm must borrow the security, enter into a bona fide arrangement to borrow it, or have reasonable grounds to expect timely borrowing.

What Should You Check on Exam Day?

• Before a member lends to or borrows from a nonmember, determine whether the nonmember acts as principal or agent.
• If the other party acts as agent, keep records for the agent, each principal, and each transaction.
• For a loan or borrow with a nonmember, use a written agreement that gives the member a contractual liquidation right after a specified financial-distress event.
• Before first borrowing a customer's fully paid or excess margin securities, provide written notice about the loan's risks and financial impact, including the member's liquidation right.
• Unless an exception applies, establish a borrow, bona fide borrow arrangement, or reasonable grounds for timely borrowing before accepting or effecting an equity short sale. Document compliance.