Securities 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:
- Loaned security
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.
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