Securities Lending: The Hidden Revenue Stream
How lending out shares can offset fees and boost returns.
Securities lending is a critical but opaque revenue source for ETFs. The fund lends its stocks to short sellers and collects a fee.
The Economics of Borrowing Shares
Short sellers need to borrow shares to sell them. They pay a "borrow fee," which can be substantial for hard-to-borrow small-cap or meme stocks. This fee generates revenue for the ETF. In 2025, ETF lending revenue surged, driven by demand for small-caps and specific "specials" (hard-to-borrow stocks).
Revenue Splits: Fund vs. Agent
The revenue is split between the lending agent (often a subsidiary of the ETF issuer, like BlackRock's lending arm) and the fund itself. Historically, agents kept a large cut (30-40%), but competitive pressure has forced this down. Today, a larger portion (often 70-80% or more) goes back to the fund. Vanguard typically returns almost all lending revenue to the fund (net of costs), while BlackRock splits it but argues their scale generates higher gross revenue.
Impact on Tracking Difference and Expense Ratios
This revenue helps offset the fund's expense ratio. In some cases, securities lending revenue can exceed the management fee, resulting in a fund that actually outperforms its benchmark index (a negative tracking difference). This is a hidden "alpha" in passive investing, and savvy investors look for funds with high lending revenue (e.g., small-cap funds) to subsidize their costs.
Rehypothecation and the Ethics of Collateral Re-Use
In securities lending and synthetic structures, collateral is often "rehypothecated" or re-pledged.
Understanding the Chain of Title
When a fund accepts collateral for a loan, it may have the right to re-use that collateral for its own funding needs. This creates a chain of title where multiple parties have a claim on the same asset. It allows for leverage to build up in the system, as one asset secures multiple loans.
Risks in the Shadow Banking System
Rehypothecation greases the wheels of the financial system but increases systemic risk. If one link in the chain breaks (e.g., Lehman Brothers), it can trigger a cascade of failures as multiple parties scramble to reclaim the same collateral. This "collateral velocity" was a key accelerant in the 2008 crisis.
Regulatory Limits on Re-Pledging
Post-2008 regulations (like Rule 15c3-3 in the US and SFTR in Europe) have placed stricter limits on how much client collateral can be rehypothecated (typically capped at 140% of the debit balance in the US), reducing, but not eliminating, this risk. Investors in synthetic ETFs should be aware of the collateral management policies of the issuer.