Securities Lending
What is Securities Lending?
Securities lending is the temporary transfer of securities on a collateralized basis from one party (the lender) to another (the borrower) for a fee. The borrower must return the securities to the lender after an agreed period or on demand. Securities lending allows the lender to earn enhanced returns on securities through finance charges and provides the borrower with many beneficial opportunities. Most securities lending is collateralized using cash, other securities, or a letter of credit. Securities lending also plays a more general beneficial role by increasing market efficiency.
Loan Framework
Securities lending transactions are more complicated than a simple loan. When a security is loaned, the ownership title transfers from the lender to the borrower. This transfer gives the borrower the shareholder’s rights, such as voting rights and rights to dividends or interest payments. However, these coupon or dividend payments are normally transferred back to the lender through equivalent payments. The borrower is also able to loan or sell the securities.
Securities loans may be either open (callable) or fixed for a specific term. Open loans are renewed each day. Equities lenders typically use open loans so these more volatile securities can be sold at any time. This loan structure also allows lenders the ability to reestablish voting rights by recalling securities. In open loan also allows the borrower to return securities to the lender.
Fee Structures
If cash is used as collateral, the fee maybe a rebate on the interest the lender earns on this cash collateral. For example, normally cash collateral is valued at 102% of domestic securities or 105% of international securities. This collateral is transferred from the borrower to the lender in exchange for the securities. The lender than rebates interest from the cash collateral to the borrower at an agreed rate. This rate is normally lower than the market rate (i.e. federal funds rate). The lender’s fee is the spread between the rebate rate and the market rate. When open lending agreements are used, the cash collateral is marked to marked daily to maintain a constant percent of collateral to securities’ value, and the rebate rate is also adjusted.
Securities loans may also be collateralized using non cash collateral. The parties agree upon the type of non cash collateral. Like securities loans using cash collateral, non cash collateral is is marked to marked daily to maintain a constant percent of collateral to securities’ value. The fee of non cash collateralized loan is determined primarily by supply and demand and collateral flexibility. Higher fees are charged for low supply securities. Lenders also receive higher fees if the collateral used is more flexible.
Primary Purposes of Securities Lending
1.Covering Short Positions
The most common reason to borrow securities is to cover a short position. When investors short securities, securities are borrowed in order to sell them in the speculation that the securities can be repurchased at a lower price in order to return them to the lender. This shorting strategy is applied in many situations. The most common situation is naked shorting, a directional bet that security prices will fall. Shorting is also used in arbitrage. Securities are often borrowed to cover a short position in a security that has been established as a hedge against a long position. Arbitragers would short a security that is overvalued and buy a related undervalued security.
Market makers also participate in securities lending. Market makers borrower securities to fill buy orders and ensure tight, two-way prices. Securities lending allows market makers to increase liquidity.
Short positions may also result from dealers need to borrower securities to provide securities for customers making buy orders or as a result of failed settlement.
2.Financing
Borrowers who collateralize loans using cash, may utilize securities lending as a form of financing. The lender receives cash in exchange for lending the securities.
3.Transferring Ownership Rights
Securities lending is also used to allow parities to take advantage of the transfer of ownership.
One primary reason for transferring ownership is tax arbitrage. Securities lending allows parties with different tax status to exchange securities, creating more favorable tax treatment for all parties. For example, a foreign holder of Italian bonds may be expecting to receive a 75% dividend. However, because the investor is not Italian, the investor is subject to a 22% withholding tax. In this situation, the foreign holder could lend the security to an Italian investor. This Italian investor would obtain a tax credit from the dividend instead of incurring withholding tax. The lender may claim 96% of the original dividend, allowing the borrower to receive the difference as a fee. Thus the borrower would enhance returns by increasing tax efficiency.
Transfer of ownership is also beneficial for dividend reinvestment plan arbitrage. When issuers of securities provide the option of a cash dividend or reinvesting in additional shares at a discounted price, many index funds that cannot deviate from specific securities weightings must take the less advantageous cash dividend. By lending these securities, the independent borrower can choose the advantageous dividend reinvestment and then sell the securities in the market. The lender receives a higher fee for sharing these securities, so the transaction benefits both parties.
Borrowing securities to deliberately increase voting power in a corporation is not illegal, but is viewed as an illegitimate application of securities lending.
Who Lends Securities?
Securities lenders are primarily asset managers, custodian banks, or third party lenders. Examples of large securities lenders are JP Morgan Chase, Charles Schwab Corporation, Citibank, and Bank of New York.
Related Sites:
http://www.stanford.edu/~duffie/DGP2.pdf
http://www.riskglossary.com/link/securities_lending.htm
http://www.isla.co.uk/sl_intro.asp
http://media.wiley.com/product_data/excerpt/10/04716789/0471678910.pdf
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