During endocytosis, membrane components move to intraluminal vesicles of the endolysosomal compartment for digestion. At the late endosomes, cholesterol is sorted out mainly by two sterol-binding proteins, Niemann-Pick protein type C (NPC)1 and NPC2. To study the NPC2-mediated intervesicular cholesterol transfer, we developed a liposomal assay system. (Abdul-Hammed, M., B. Breiden, M. A. Adebayo, J. O. Babalola, G. Schwarzmann, and K. Sandhoff. 2010. Role of endosomal membrane lipids and NPC2 in cholesterol transfer and membrane fusion. J. Lipid Res. 51: 1747-1760.) Anionic lipids stimulate cholesterol transfer between liposomes while SM inhibits it, even in the presence of anionic bis(monoacylglycero)phosphate (BMP). Preincubation of vesicles containing SM with acid sphingomyelinase (ASM) (SM phosphodiesterase, EC 3.1.4.12) results in hydrolysis of SM to ceramide (Cer), which enhances cholesterol transfer. Besides SM, ASM also cleaves liposomal phosphatidylcholine. Anionic phospholipids derived from the plasma membrane (phosphatidylglycerol and phosphatidic acid) stimulate SM and phosphatidylcholine hydrolysis by ASM more effectively than BMP, which is generated during endocytosis. ASM-mediated hydrolysis of liposomal SM was also stimulated by incorporation of diacylglycerol (DAG), Cer, and free fatty acids into the liposomal membranes. Conversely, phosphatidylcholine hydrolysis was inhibited by incorporation of cholesterol, Cer, DAG, monoacylglycerol, and fatty acids. Our data suggest that SM degradation by ASM is required for physiological secretion of cholesterol from the late endosomal compartment, and is a key regulator of endolysosomal lipid digestion.