Brian BollenSecurities lending is when an owner of a fixed income stock or other security lends it to someone else. The borrower must stump up collateral while they hold the borrowed security – this might be in cash but it might be another security or a mix of securities. The value of the collateral will be higher than the value of the stock lent and marked to market daily.
Crucially, the title and the ownership of the security transfer to the borrower while the security is on loan. And the borrower has an obligation to redeliver a like quantity of the same securities at a future date.
Investment banks, brokers and market-makers borrow securities for a number of reasons. These include:
- Ensuring settlement of trades can take place on the due date
- Enabling market-making and other trading activities such as hedging and short selling
- Transforming or upgrading collateral
There are four parts to the structure and process of securities lending and borrowing. These are the:
- Lender
- Borrower
- Loaned security
- Collateral
The terms of a stock lending transaction are fairly standard. However, specific details such as the length of the loan (whether it expires at a pre-determined date or on demand by the lender) and the rates offered by the custodian are customised to suit the needs of both the lender and borrower.
Soured reputation
Securities-based lending has a soured reputation. Partly, this is because it is strongly linked to short selling. An investor borrows stocks to sell them to force the price of those stocks down. The borrower hopes to buy back the borrowed stock at a lower price, making a profit. And that’s not the only reason stock lending gets a bad press.
Supporters of securities lending say it has long been misunderstood and unfairly blamed for market events. Opponents who see it as the work of the devil cough discreetly and point to incidents of abuse involving the likes of Orange County and the late disgraced tycoon Robert Maxwell in the early 1990s as prime reasons why it remains controversial.
A more recent example thrusting securities lending into the spotlight comes from Philadelphia. In February 2015 came the news from the city of brotherly love that Counsel for Plaintiffs had reached a US$36m settlement with Northern Trust Company and Northern Trust Investments.
The plans claimed Northern Trust invested collateral posted by borrowers of the securities in risky investments: sub-prime mortgages, special investment vehicles, and long-term floating notes (Diebold, et al. v. Northern Trust Investments, N.A. et al).
They said this resulted in hundreds of millions of dollars in losses for the retirement funds. Northern Trust denied any wrongdoing or liability in this and a related case.
Securities-based lending is nothing new
Securities lending is not a modern phenomenon. It is recognised to have been a part of investment life on the Amsterdam stock exchanges in the 1600s. But the market as it is today owes much to the development of portfolio theory, the ever-expanding use of derivatives and, of course, technology.
Throughout its history, technology has underpinned changes in securities lending and kept the securities lending industry moving forward. Technology is what continues to drive the business. First, technology helped to replace manual recordkeeping. Then it improved on it, then dramatically increased productivity.
Technology allowed for a much larger volume of business without a proportionate increase in staffing, expense or risk. Whatever has been achieved so far, there remains work to be done. The pursuit of greater efficiency and transparency is relentless.
Why lend securities?
If it is so controversial, why do asset owners do it? The simple answer is money. Stock lending is used by investors and beneficial owners to generate additional income from their investment portfolios at little or no risk.
The generation of additional revenue through securities lending is a compelling reason to consider setting up a programme, says John Wallis, London-based global head of business development and co-head of European securities lending at Brown Brothers Harriman (BBH).
The value of securities on loan in the securities lending marketplace reached more than $2trn in March this year, the highest value since DataLend began tracking the market in 2013.
The lendable value - the value of securities lenders have made available for borrowing - surpassed $16trn. This is also a DataLend record.
Key statistics on stock lending
Global Securities Lending Market key statistics (as of March 9, 2017):
- On-loan value: $2.00trn, +$180bn year-on-year (YOY)
- Lendable value: $16.04trn (+$2.75trn YOY)
- Unique securities on loan: 45,200
- Cash collateral as a percentage of on-loan balance: 39.48% (-6.39% YOY)
- Non-cash collateral as a percentage of on-loan balance: 60.52% (+6.39% YOY)
Lenders earned $9.16bn in securities lending revenues in 2016. This includes:
- $4.67bn in North America
- $2.64bn in Europe
- $1.67bn in Asia-Pacific
- $182m in the rest of the world
Growing number of lenders
BBH's own recent experience reflects the continuous evolution of the market, says John Wallis. BBH is undergoing a renaissance in its own particular niche, which is meeting the particular needs of asset managers running registered funds such as UCITS (undertakings for collective investment in transferable securities) and mutual funds.
People who declined invitations to discuss the issue with BBH in the past are now happily lending securities from their portfolios, he adds. The additional revenue is going straight into the pockets of end investors.
In the prolonged low interest rate environment it is widely expected by industry participants that beneficial owners who do not currently have a programme in place will adopt securities lending for the first time. Those who do have a programme are expected to expand its use in an attempt to boost overall portfolio returns.
Secondary investment strategy
Experienced beneficial owners caution, however, that the possibilities should not be overstated. Securities lending is a secondary element of the active investment strategy, overlaid on the primary strategy as a means of enhancing returning and offsetting a fund's costs. Primary investment is the dog. Securities lending is the tail. The tail must not wag the dog.
Marthe Skaar, a spokesperson for NBIM, the Norwegian Wealth Fund, for instance, provides a sense of perspective. She says that efficient use of its equities and fixed income holdings through securities lending is an integrated part of its asset management.
It uses both direct internal lending to selected borrowers and external lending through an agency agreement established with its custodian, which can lend to borrowers approved by Norges Bank. At the end of 2015, the fund's report showed that the amount of equities and bonds out on loan corresponded to around just 6% of the net asset value of the fund.
The additional revenue earned from this activity over the year amounted to five basis points, just over NKR 3.3bn, compared with NKR 2.7bn in 2014.
Volume versus value
BBH's Wallis identifies two main approaches to securities lending. One is focused on volume. The aim is to maximise revenue by lending as much as possible of a portfolio on a general collateral basis, earning a few basis points.
The other is focused on value. The aim is to charge what can be very significant fees for stocks that are in high demand (specials, as they are known in the industry's jargon).
It is the latter approach that traditional asset managers in BBH's niche market tend to prefer. An asset owner can lend a stock and take in a top-rated government bond as collateral, he observes. This delivers a huge upgrade in the quality of what is in the portfolio, and the government bond will soar in value in the event of market panic.
Transfer of title
The importance of the transfer of legal title is two-fold. First, it allows the borrower to deliver the securities onward, for example in another securities loan or to settle an outright trade. Second, it means that the lender usually receives value in exchange for the disposition of legal title (whether in cash or securities), which ensures that the loan is collateralised.
The risks inherent in lending securities are not always readily apparent, but must be recognised as important consideration when operating a securities lending programme. The range of major risks that lenders must manage includes
- Counterparty risk
- Collateral adequacy
- Collateral title risk
- Delivery risk
- Regulatory risk
- Market risk
When establishing or analysing a securities lending programme, several areas must be carefully considered. These include:
- Proper risk controls and operational efficiency
- Maintaining appropriate levels of collateralisation through daily mark-to-market
- Clearly defined lending and reinvestment guidelines
- Execution of appropriate legal agreement
- A means to evaluate or benchmark the performance of the programme
Legal title passes from lender to borrower
Legal title of securities loaned passes from the lender to the borrower at the time of the loan. It passes back to the lender when the securities are returned. The lender retains risk and exposure to the market place for the loaned securities as well as all the benefits including corporate actions or dividends.
The lender does lose the voting rights to the securities over the loan period. The lender has the right to recall securities on loan at any time, unless otherwise agreed with the borrower.
This represents a risk to the borrower that must be managed. For this reason, borrowers prefer to do business with passive long-term owners who are less likely to want to sell a security during the loan period.
Evolving thriving securities lending
Securities lending continues to thrive as a practice. It is continuously evolving to meet the new demands and challenges presenting themselves in the financial industry, exacerbated by the regulatory landscape.
The arguments for and against amongst beneficial owners will likely never come to a conclusive end. But there is little doubt that the development in relatively recent times of extensive and reliable market performance data can help by increasing transparency and efficiency.
Portfolio managers have a duty to wring every last basis point out of the securities in their care. The incremental revenues might remain modest. But a few additional basis points of income a year over a five-, 10- or 20-year time horizon can provide a welcome boost to a pension fund and therefore to its pensioners.
Ultimately, we can all benefit from successful securities lending programmes.
