Securities lending is the act of lending or loaning a financial security, a stock, bond, or derivative, to a firm or an investor. It involves the borrower to provide collateral for the security that they are borrowing. The collateral can be in the form of either cash, bonds, shares or letter of credit (LOC).
A securities lending agreement governs the terms of a security lending loan. The agreement includes the type of collateral – cash, securities or LOC – of value equal to or greater than 100% of the loaned security. The borrower of the security will pay a lending fee, which is typically paid monthly to the lender. Also, the borrower is contractually obligated to return the loaned security either on a pre-determined date or on-demand by the lender.
One of the most common applications for securities lending is short selling. A short sell is when a party sells a security and then repurchases it at a date in the future. It is a trade that takes the position that the underlying security value will decrease in the future.
However, to short sell, a party must be able to sell the security first. It is commonly achieved through securities lending. A party would borrow a security, provide collateral, sell the security, then repurchase it in the future (hopefully at a lower price) and return the security to the lender. The collateral that the borrower supplies is typically equal to the security.
Furthermore, if the underlying security pays a dividend or accrues interest during the period the borrower holds the security, the borrower must pay the dividends or accrued interest to the lender. Securities lending is also common among funds. Funds will lend a security to earn a lending fee, which is paid by the borrower.
Securities Lending Benefits
From the lender’s point of view, the benefits of securities lending include the ability to earn additional income through the fee charged to the borrower to borrow the security. It could also be viewed as a form of diversification.
From the borrower’s point of view, it allows them to take positions like short selling. It also gives investors more options to take different views on the market. For the market as a whole, as mentioned above, it helps to increase liquidity. Increasing liquidity in the market tends to also tighten spreads, which is beneficial to all market participants as the gap between the bid and the ask decreases.
Securities Lending Risks
All investment strategies involve risk, including securities lending. As a lender, the main risk is that the value of the collateral decreases below the cost of the security that was lent out. Another risk to the lender could be that the borrower becomes insolvent and is unable to return the borrowed security.
Additionally, a timing risk could occur for the lender if the lender gives the borrower the security before receiving the collateral. As a borrower, the main risk is that the value of the security increases after a short position is taken. When the borrower takes a short position and the value of a security increases, the borrower essentially has sold low and bought high, losing money.
Securities Lending and Market Liquidity
Empirical evidence supports that securities lending helps to provide liquidity in over-the-counter markets. It helps facilitate various trades that allow investors or institutions to hedge, take a bespoke position, or in arbitrage situations.
Securities lending is a common practice in insurance companies. Insurers may take long-term investments to match with insurance liabilities. Thus, the securities are not actively traded. It gives rise to the opportunity for insurance companies to lend the securities and earn a fee to boost returns.
Furthermore, if cash collateral is given to a lender, it is typically reinvested. The reinvestment increases trading in the markets, which tends to lead to an increase in market liquidity and the tightening of spreads.
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