Securities Lending Explained

From it's initial "back room" roots, securities lending has become an integral part of the capital markets. The business, which originated in the United States in the early 80's, has expanded rapidly in recent years and is now a 24 hour global activity. Securities lending adds liquidity and efficiency to the market place and supports trading activities/strategies in all major markets, as well as some of the emerging markets.

Securities lending provides the lender of securities with a low risk yield enhancement to his portfolio, while enabling the borrower to cover failed trades and to hedge/ arbitrage in the market.

Recent figures representing market size with respect to securities lending in Asia can be seen here.

The Transaction

In very simple terms, a securities borrow/loan (SBL) transaction involves the temporary loan of securities by a lender to a borrower.

The reasons why a borrower needs to borrow securities vary, but generally securities are needed to support a trading strategy or a settlement obligation.

As a SBL transaction is entered into, the borrower provides collateral to the lender. Collateral can be in the form of cash or non-cash (e.g. letter of credit) and must be equal to or greater than the market value of the securities borrowed. On receipt of collateral, the lender will then deliver the securities to the borrower. When cash collateral is used, the lender will invest the cash and derive a yield. See the flowchart below for an illustration of the transaction.

Throughout the life of the loan, the market value of the loaned stock will fluctuate. To maintain sufficient levels of collateralisation for open loans, a daily mark to market is done and the amount of collateral is increased or decreased accordingly.

When it is time to close the loan, the borrower returns the securities to the lender. Once the lender receives the securities, he then returns the collateral to the borrower.

Borrowing Fee Arrangements

The borrower pays a fee to the lender for the use of the borrowed securities. In the case of non-cash collateral, the lender will charge a fee to the borrower. When cash collateral is used, the lender's fee is the difference between the yield on the invested cash collateral and the rebate interest paid to the borrower.

The following picture illustrates a loan versus cash collateral.

Where a lending agent is involved in the SBL transaction, the borrowing fee is divided between the owner of the securities and the agent lender.

Delivery of Collateral

The borrower must have collateral in place with the lender at the same time as or prior to the delivery of the securities. Normally there is a one day pre-pay (i.e. the borrower gives the collateral to the lender one day before contractual settlement of the loan).

The purpose of the pre-pay is that it allows the lender to cancel the delivery instruction prior to the delivery of the stock in the event that collateral is not received.

Delivery versus payment, also called DVP, may only be available in certain markets and is most common when collateral is pledged in the same currency as the loaned stock.