Finance - Securities Lending

Hi,

In this post I’m going to explain few concepts of Securities Lending. Most of us might not be familiar with “Securities Lending”, first let me tell you what securities are.

What is Securities Lending?

Securities lending is an investment strategy in which investors make short-term loans of their securities to generate incremental revenues from their portfolios. The securities lent typically include a broad array of equities as well as fixed income securities, including government and agency securities and corporate bonds. Small cap stocks, growth stocks, global equities and government bonds are generally among the most attractive.

Why lend securities?

• Increase overall performance
• Offset expenses associated with maintaining the portfolio
• Maximize opportunities to leverage their portfolio
• Finance fund-specific projects
• Retain ownership benefits (except right to vote)

Why borrow securities?

Borrowers are usually broker-dealers with proprietary trading desks and prime brokerage units supporting hedge fund activities. Generally, they borrow securities to:

• Facilitate sophisticated trading and arbitrage strategies, and to cover shorts and prevent fails
• Engage in strategies such as risk arbitrage and pairs trading
• Participate in dividend arbitrage and other financing activities
• Finance inventory and manage balance sheets
• Act as an intermediary — as with agent banks and prime brokerage

What type of collateral can be used?

Typically, collateral consists of:

• Cash (USD, GBP and Euro primarily)
• U.S. government or agency securities or G1O debt and Supernationals
• Other U.S. and/or foreign securities as allowed by the lending institution
• Letters of credit

How is revenue generated?

A lender earns a return from these transactions in several different ways, depending upon the type of collateral posted by the borrower against securities loaned.

• Cash as collateral — the cash is reinvested into short-term money market instruments. In return, the lender pays the borrower a rate of interest on the cash collateral called the “rebate” rate. The lender then earns the spread between the investment rate of the short-term vehicle and the rebate rate.
• Securities or a letter of credit as collateral — the borrower pays the lender a set fee in exchange for the borrowed securities.

In an exclusive securities lending arrangement, also referred to as a “principal arrangement”, the lender earns a fee from the borrower for the exclusive right to borrow from a portfolio plus the spread between the reinvestment rate of cash and the rebate paid under a cash collateral scenario.

What determines the potential revenue?

In a traditional agency program, fees are negotiated on a trade-by-trade basis. At eSecLending, price is effectively established for portfolios, or segments thereof, through a competitive auction process. Revenue can be affected by many factors. These include:

• Availability of security in open market
• Value of portfolio
• Asset class
• Duration of loan
• Size of individual holdings
• Type of investment strategy
• Market / geographic diversification
• Dividend yield of security
• Tax status of underlying lender

Who arranges the transactions?

Market facilitators arrange and facilitate securities lending transactions. These include custodial banks, third party lending agents, broker-dealers acting as principals and eSecLending, with its unique role as a securities lending manager.

Here is how each type of operates:

• Custodial agent lenders act as an intermediary lending agent in a “best efforts,” non-guaranteed program, lending individual securities for a percentage split of the revenues generated.
• Third party agent lenders facilitate programs similar to the custodial structure above; however, they act as a specialist lending agent and do not custody the securities.
• Broker-dealers as principal borrowers (exclusive principal deal) accept a guaranteed fee for the exclusive right to borrow from a portfolio for a specified term.
• Securities lending managers (such as eSecLending) arrange exclusive principal deals, as described above, via a competitive auction process with multiple borrowers, rather than a traditional process with just one borrower

What are the risks?

When properly planned and executed, securities lending is a low-risk investment strategy. Since all investment activities involve some risks, lenders should consider the following with respect to their securities lending activities:

RISK	CONTROLS
Counter Party Risk Borrower defaults or is insolvent, failing to re-deliver the borrowed securities.	· Capital and rating requirements, extensive ingoing credit reviews and VaR-based credit limits. · Daily collateral mark-to-market. · Indemnification insurance provided by third party in the event of borrower default.
Cash Collateral reinvestment Risk Investment default, credit risk and liquidity or duration mismatch in the cash reinvestment portfolio.	· Monitor and manage average-weighted life, credit quality, sector allocation, duration and liquidity. · Establish conservative reinvestment guidelines · Manage unbundling of “core” cash management
Operational Risk Processing mistakes and errors in the administering lending programs.	· Daily reconciliation between program participants · Process and procedures in a controlled environment · Routine reporting and compliance monitoring
Legal/Contractual Risk Compliance with program guidelines.	· Standardized documentation · Audit/compliance reporting and oversight · Premier industry experts as external legal counsel.

Thanks,

Paresh Bhole