IT IS one of finance's odder rituals: every year come springtime around $100 billion in European shares goes on a little holiday. In the days running up to annual dividend payments of listed companies, many long-term shareholders, such as pension funds, lend their holdings to a third party. A week later, once the dividend has been paid to the temporary owner, the shares are returned safely to the pension funds" vaults, where they remain until the following spring. The brief excursion is not designed to improve the share certificates" complexion. Its purpose is to circumvent withholding taxes on dividends, which some investors have to pay upfront and others do not. The tax-exempt borrower pays a rental fee equal to the dividend that the pension fund will now miss out on, minus a cut for itself and a clutch of banking middlemen. All sides are better off, bar the taxman. The European dividend-arbitrage trade, as it is known, is just one facet of the "securities lending" industry. Globally, over $1.5 trillion in shares and bonds are out on loan at any one time, according to Markit, a research firm. A further $12 trillion is on offer. Many staple operations of high finance, such as the ability for investors to bet on falling share prices, depend on securities lending. But new regulation, in particular Europe's financial-transaction tax, could make it much more difficult - even as other new rules may make it more necessary. A wide coalition is defending the status quo. Long-term owners of stocks who agree to lend them, such as pension funds and insurance companies, are keen on the income stream that this generates: $11 billion globally last year, according to Markit. "We look at securities lending as a way of unlocking incremental returns for our investors without undue risk," says David Lonergan of BlackRock, an asset manager. For a balanced portfolio which includes both shares and bonds, the uplift to overall returns is in the order of 0.05-0.10% a year, explains James Slater of BNY Mellon, a financial group which helps to arrange share loans. That is certainly worth grabbing in a low-interest-rate environment. The Teacher Retirement System of Texas, a pension fund, says it made an average of $100m a year in the past decade from lending securities. Borrowers of securities are a diverse bunch. Hedge funds are the most visible. Those bearish on a particular firm can borrow its shares, sell them immediately, and if the price does indeed drop replace them later at a lower cost. Brokers, for their part, borrow securities to plug temporarily the gaps between whatever securities they promised their clients and what they were able to source from the markets. Stock lending is also used by firms that want to trade low-grade securities (such as equities) for better-quality assets (such as government bonds), a piece of financial alchemy known as "collateral upgrading." Banks resort to this to help them meet regulatory capital requirements, or to get further financing from a central bank that requires high-quality assets to be posted as collateral. Multinationals also need safe assets to buy and sell derivatives, which they use, for example, to lock in interest rates or currency levels over time. This points to a hazard inherent to securities lending: your counterparty has to be around to return what it has borrowed from you. Industry boosters say any risk is mitigated by stringent collateral requirements: borrowers have to leave ample cash (or other assets) with the lenders of the stock. They note the orderly resolution when Lehman Brothers, an investment bank, collapsed in 2008. But things do not always go that smoothly. Problems can arise when the collateral put up by the borrower is itself reinvested. AIG, an insurance group which loaned out $90 billion of securities on its balance-sheet, used the cash it accumulated as collateral to invest in risky and illiquid mortgage bonds. When its counterparties hurriedly returned their borrowed securities and asked for their cash back, American authorities were tapped for a bail-out that ultimately reached $182 billion. "Securities lending made AIG vulnerable to a phenomenon akin to a bank run," says a market participant. Regulators also fret that assets might not be where they are expected to be as a result of lending activity, particularly if borrowed securities are then used as the raw material for other, unrelated transactions. Hence a slew of new rules. American authorities want to limit the maximum exposure between firms, including what they have loaned to each other. Basel 3 banking regulations demand that intermediaries arranging the trades set more capital aside if they insure their clients against mishaps. Europe's regulators want to make sure that the profits from securities lending are passed on to pensioners rather than filling the coffers of the firms which handle their investments - which has already triggered a few lawsuits. On borrowed time The big unknown is the impact of a financial-transactions tax being mulled by 11 euro-zone countries. The combination of low margins, large volumes and repeated transactions makes securities lending vulnerable to even the smallest levy. A European banker says half the securities-lending industry could be killed off; others think it could be even worse. Participants on all sides are lobbying for securities lending to be excluded from the scheme. For now, the future of securities lending looks uncertain rather than outright gloomy. The danger is that it will be stymied just when it will be needed to fuel derivatives trade. Regulators in both America and Europe now want all derivatives contracts to change in ways that will require much higher levels of collateral - and thus securities lending. Should such financial activity indeed be severely limited, nobody will much miss the tax-dodging holiday of European shares in springtime. Other benefits would be harder to replace.