The author summarizes the institutions involved and the rationale and tax/regulatory status of the European dividend-arbitrage trade and discusses some of the uncertainties that this strategy will likely encounter in the future.

The European dividend-arbitrage trade is a way for such long-term shareholders as pension funds and insurance companies to circumvent taxes on dividends by lending them to tax-exempt investors on a short-term basis. Approximately $1.5 trillion in securities is out on loan at any one time, and another $12 trillion is on offer. The income stream generated from this type of lending was $11 billion globally in 2012. Asset managers are able to unlock up to 0.10% a year in incremental return without a commensurate level of risk, which is appealing in the current low-rate environment. In the past 10 years, a pension fund based in Texas made an average of $100 million a year from lending securities.

One risk is that lenders will reinvest collateral in risky and illiquid assets, which could adversely affect the borrowers’ ability to get their cash back. Regulatory requirements in the United States limit the maximum exposure between institutions. Basel III banking regulations require that the bank intermediaries arranging the trades set additional capital aside if they insure their clients.

Eleven eurozone countries are currently discussing a new issue that will affect the dividend-arbitrage trade: the possibility of a financial transaction tax. Securities lending is characterized by low margins, large volumes, and repeated transactions, which make it susceptible to any additional tax requirement. In addition, regulators in both the United States and the eurozone want to require higher levels of collateral for securities lending.

It is reasonable to conclude that this trade will be adversely affected by changes in taxes and regulatory requirements. The author could conduct a more thorough analysis of the impact, assuming these tax and regulatory changes take effect.