Introduction
Securities lending refers to the temporary transfer of securities from a lender to a borrower, typically in exchange for cash. The borrower will pay a fee to borrow the security and return it at some point in the future. It is important to understand what you are getting into when you lend your shares.
What is securities lending?
Securities lending is a type of financing, which involves the temporary transfer of pledged securities as collateral. The borrower then receives typically cash in exchange which they would pay back over a set period of time, with a relatively low interest rate. The shares are held in a custodian account but are in possession of the lender who controls those shares until the loan is repaid. During that type rehypothecation may occur.
The key difference between securities lending and other types of financing is that often borrowers can take out loans with competitive loan to value ratios and also with an option of non-recourse. This can be extremely beneficial for investors if they have temporary excess cash and want to look to invest in other areas to take profit, with the option of never actually returning the funds they borrowed, should they wish to forego the collateral pledged.
This type of lending is a strong option for borrowers who need cash more immediately and do not wish to go through a slow process with a large financial institution, particularly if they are a high net-worth client but not quite a billionaire. This allows them to reduce the bureaucracy and increase the speed in which they can access funds.
Borrowers often wish to pledge a portfolio of securities than just a single stock, and often borrow against tranches of shares, rather than the whole portfolio or holding at one time.
Payment can be made within a week so long as the KYC process can move smoothly and efficiently.
How does it work?
Securities lending is a simple concept, but it can be confusing to the first time borrower. Here’s how it works:
You loan your shares to a broker or other financial institution for a fee (the “loan rate”). The loan period may last for six months, one year or longer.
While you’re lending your shares to the lender, they will take control of the shares in a custodian held account
As part of the loan agreement, usually a broker fee is paid, and in order to manage lender risk, a first instalment is usually paid within 14 – 30 days
Depending on the terms of the loan contract, the lender may offer a non-recourse option, which gives the borrower the option of never paying back the loan in full but signing away the collateral pledged, without any further recourse
Period of the loan is typically 24-36 months with an interest rate of 2-3% and a loan-to-value of 50%-80%. This is double what financial institutions usually charge.
The borrower will pay a fee to access liquidity as part of the loan and has the option for the loan to be non-recourse
The fee paid depends on the type of security, the amount borrowed and the duration of the loan. The securities lending market is very liquid, with several thousand securities being borrowed every day by institutional investors who use this activity as an alternative funding source when they need money quickly, or find that their cash position is too low to support trading activities.
Why would someone lend their securities?
There are several reasons someone might want to lend their securities:
Profit from the difference between the loan rate and the return of their security
Reduce trading costs by using a buffer account instead of margin accounts. This is particularly useful for institutions that want to hold assets but don’t want to be exposed to huge losses if things go wrong. For example, banks often use securities lending programs as buffers against losses in case they need money quickly (e.g., during an emergency).
They can also use it because it reduces liquidity risk, which means less capital is required in reserve for emergencies or withdrawals of funds from depositors who may panic during times of crisis (e.g., when there’s bad news about company A or B).
Increase liquidity – this means having more cash available so that you can buy other assets when opportunities arise without having to sell something else first before buying a new item because we already have too much invested at one place, even though its value may drop due to unforeseen events
What are the main risks of securities lending?
Securities lending comes with its own risks, including the risk of losing money on securities that you lend. If you are lending more than half of your portfolio value in any given month, then it’s important for you to be aware of these risks and make sure that you don’t get over-extended.
Another risk is not knowing what you are getting into when it comes to securities lending. There is a lot involved in the process of making an agreement with another party (the borrower), so understanding all the terms will help ensure that both parties are satisfied with their arrangement.
Additionally, there are many other potential problems arising from securities lending: not knowing how much interest rate or fee should be charged; not knowing how much money will come back at the end; or not understanding how much capital gains tax may be owed on gains made through this type of investment opportunity.
Who sets the loan rate?
The loan rate that you receive is based on the lender’s assessment of their own risk tolerance. The most important factors are:
- The borrower’s creditworthiness
- The security’s creditworthiness, and
- The market environment
What types of securities can be lent or borrowed?
Securities lending allows a borrower to use securities as collateral for a loan, often from an investment bank. The borrower will then typically sell the borrowed securities and use the proceeds of that sale to meet their obligations.
There are many different types of securities that can be lent or borrowed: shares, bonds, options, futures and other derivatives. Debt securities also can be lent or borrowed but there are some additional requirements for investing in them compared with equity instruments.
Does this activity increase risk to the securities lender?
When you lend securities to a borrower, there are three possible outcomes:
The borrower may default and fail to return the shares. If this happens, your lender will want you to replace those shares (or its equivalent value in cash) immediately. The inability of a borrower—who is contractually obligated—to return your securities can be costly for your firm and could cause it serious reputational harm.
The borrower may sell the loaned security instead of repaying it at maturity date. If this happens, the proceeds from selling these loans do not belong to you; they belong to your client who lent them out originally (even though they’re still legally yours).
It is important to understand what you are getting into when you lend your shares
If you are considering lending your shares to another party, it is important to understand what you are getting into, and ensure that you have a thorough chat with the lender around the options available.
Conclusion
Securities lending is a complex process that involves many different parties. It can be an attractive form of accessing capital quickly, but it also comes with some risk should the markets face alot of volatility, but the advantages often outweigh the risk, given the attractive interest rates and high loan to value ratios on offer