Understanding Securities Lending
Dealing in securities in a financial market, especially the stock market, can be filled with as many uncertainties as opportunities. Often, there are situations where an investor can be caught without securities or enough funding to meet his investment and trading requirements.
This is where the concept of securities lending becomes relevant and even indispensable.
What is Securities Lending?
Securities lending is a form of temporary loaning or transfer of securities to a borrower. The securities transferred can be shares, derivate, bonds or any stock that is traded. In exchange, the borrower transfers other securities to the lender as collateral. In this whole transaction, the borrower has to pay a borrowing fee or loan fee (along with an interest due) to the lender.
In securities lending, the title and the ownership are also transferred to the borrower. The loan fee and interest are decided based on the Securities Lending Agreement and must be decided before the stock is borrowed by a client.
The Purpose of Securities Lending
So why would anyone want to borrow a stock or share or a financial security? Borrowing cash or capital for personal or corporate needs is common enough and this usually involves a collateral too. But what situation typically requires a concept like securities lending?
One of the common uses of securities lending is to bail out an investor who has been short selling. This is the practice of selling shares that are not owned by the seller. This actually is a common form of trading where a seller, anticipating a stock to drop its price, places a sell order without being in possession of that stock. In this scenario, he is forced to borrow that share from elsewhere to settle that transaction.
Short sellers are in the business of buying a stock when it is low and selling it when it appreciates. To aid their strategy, securities lending helps them bridge this gap and get them access to the specific security they have to submit. The seller in this case is able to borrow the same stock and make a sale. Later, he can buy it back at a lower price and, thereby, make a profit before returning the shares to the lender.
This is where a tool like securities lending helps short sellers to trade in the market without having to buy the stock. It is also possible for investors to buy on margin which is about borrowing money against securities to buy more. This is beneficial for the market as more activity creates buoyancy and opportunities for more turnover of a business.
Another purpose of securities lending is also to facilitate investment companies to make more revenue through fees and interest payments.
How does Securities Lending Work
Securities lending, typically, involves a broker or a middleman and is not a facility that is available directly to the individual or retail investor. But it certainly can involve a single investor who might be in need of borrowing a security or borrowing against one.
The requirement for securities lending arises in more than one situation. It could either be someone looking to borrow securities to replace ones that he has short sold. Or it could be a case of needing funds against the collateral pledge to buy other stock. These are the classic cases where a security lending comes into play.
To formalise this transaction, depending on whether securities are being borrowed or a loan being taken, a securities lending agreement or a loan agreement, respectively, need to be entered into. The agreements carry all the terms of the contract and the main points include the type of collateral, duration of the loan, the interest rate applicable, the fees and other charges.
The collateral pledged should be a minimum of 100% of the loan amount. In the case of securities being borrowed, the collateral needs to be higher to provide for the volatility in the market value. The interest rate and other fees applicable varies from case to case and can depend on the ease of availability of the securities being borrowed or any other influencing factor.
In the case of an investment fund, securities lending is usually done by either the fund themselves or through an agent lender who is an intermediary who liaises between the fund and the borrower. In this case, the borrower approaches the agent lender and offers collateral that is indemnified by the agent who also covers the risk for the fund. The fund releases the securities through the agent to the borrower. Needless to say, borrowers would need to have an excellent credit history and rating to qualify for such lending.
Benefits of Securities Lending
✅ One of the main benefits that securities lending offers the lender is the potential to earn interest payments on the securities that he owns. It is a way of unlocking the value of the asset without having to liquidate it. The returns in the form of interests that are received are, typically, monthly payments and a good source of cash flow too.
✅ Should the need arise, the lender still has the power and right to sell off these securities. This, in particular, is an advantage as his assets are not really locked up and are just as liquid as it would be had they not been lent.
Drawbacks of Securities Lending
❌ From the lender’s standpoint, one of the drawbacks, when he lends his securities, is that he may not have the voting rights for that stock during this period. He may not also be eligible for dividends.
❌ Also, another drawback in the case of securities lending is that he may have to forego the coverage by Securities Investor Protection Corporation or SIPC protection on the investments during this period. This means that, should a brokerage firm that has custody of his securities become bankrupt, he will not enjoy the right to be protected if he were a regular customer.
❌ There is also the risk of the lender having to face a possible loss of his securities in multiple scenarios. If the borrower happens to become insolvent and there is a steep fall in the value of the collateral held, the lender stands to lose some or all of the money lent.
Examples of Securities Lending
To understand the concept of securities lending in practice, here is a scenario that can explain it better. Let us imagine Mr Smith, an experienced and expert investor who frequently trades in the stock market.
Mr Smith decides to take a short position on XYZ Company that trades for $120. His research tells him that the stock price is likely to fall to under $100 on the back of some unfavourable conditions plaguing the sector the company is in.
As Mr Smith does not have any shares of XYZ, he would have to borrow it from elsewhere to sell it. For this, he approaches a broker who can lend him the company’s shares. He asks the broker for 100 shares and enters into an agreement with him that contains the terms that include the fees and the rate of interest that are applicable.
The broker lends 100 shares to Mr Smith who places a sell order in the market for $100 each for a total consideration of $12,000. He uses the delivery received from the broker to square the sell order. In a week’s time, as per his calculation, the price of ABC Company does drop to $100 following which, he buys 100 shares costing $10,000.
This transaction leaves Mr Smith richer by $2000 (minus the fees and interest paid to the broker) thanks to the securities lending facility. Without it, he may not have been able to sell something he did not own or have the required funds to buy it back.
On another occasion, Mr Smith gets to know that ABC Corporation is expected to post excellent results following some good product launches that have seen increased sales. Market research points to the share price seeing an appreciation in the short term.
Currently, ABC Corp. is trading at $50 and the expectation is the price will touch the $60 levels. But Mr Smith does not have the required funds to buy 100 shares. As he does not want to pass up on the opportunity to benefit from the price rise, he will need to raise $5000 to buy the 100 shares.
He decides to avail of securities lending as the working capital. As he has other stock that he could pledge as collateral with a lender, he approaches a broker who asks for securities worth $10,000 to release $5000. There are terms which include a 50% margin lending against the valuation of the shares pledged, the fees for the transaction and the interest rate applicable.
With this infusion of working capital, Mr Smith buys 100 shares of ABC Corp. for $5000 and holds it for two weeks. As per his estimate, the share price appreciates to $60 each upon which, he sells it for a consideration of $6000. This transaction too earns him a profit, this time of $1000 (minus the fees and interest due to the broker).
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