A comprehensive guide to securities lending

What is securities lending?

Securities lending is a crucial practice in financial markets that enhances liquidity and supports diverse trading activities. By lending shares of stock, commodities, or other securities to investors or firms, securities lending facilitates a range of market operations, from short selling to meeting settlement obligations. During the loan period, the borrower provides collateral—such as cash or other securities—while the title and ownership of the securities are temporarily transferred.

This practice not only promotes market efficiency but also benefits the lender by generating a fee that can boost portfolio returns. Additionally, the lender retains the financial gains, including dividends. Governed by carefully structured agreements, securities lending helps manage risks and ensures the return of the securities. Overall, securities lending, whose global market boasted a size of EUR 27.2 trillion at the end of 2023, plays a significant role in the smooth functioning of financial markets by enhancing liquidity and supporting various trading strategies.

Key differences between repo and securities lending

Comparing it to repo trading – another form of securities financing – helps to understand the concept of securities lending.

Repo trading and securities lending both involve the temporary transfer of securities in exchange for collateral, which can be cash or other securities. In both scenarios, the ownership of the securities is temporarily transferred to the borrower, enhancing liquidity or meeting short-term financing needs.

Repo agreements primarily aim to provide short-term liquidity. In a repo transaction, the seller borrows cash from the buyer, using securities as collateral. This arrangement involves selling securities with an agreement to repurchase them at a later date for a predetermined price. During the repo period, the lender temporarily assumes ownership of the securities and may sell or use them, although this is not usually the primary intention.

In contrast, securities lending facilitates activities such as short selling, settling failed trades, or executing arbitrage strategies. This process involves the temporary transfer of securities from a lender to a borrower, with the agreement to return the securities at a later, typically unspecified, date. The borrower provides collateral, which can be cash, other securities, or a letter of credit, to the lender. The primary goal of securities lending is to borrow securities rather than cash.

While most repo trades are driven by the need for cash, some segments of the repo market focus on the demand to borrow specific securities. Conversely, investors can also use securities lending to raise cash.

Securities lending and repo trading also differ in their collateral requirements and the handling of ownership. In repo trading, fixed-income instruments like bonds are commonly used as collateral. The primary aim of a repo transaction is to facilitate cash borrowing and lending. The seller (borrower) provides securities to the buyer (lender) with a promise to repurchase them at a later date. During this period, the legal title of the securities transfers to the lender, who generally holds them without the possibility of the seller reclaiming them unless explicitly agreed.

In contrast, securities lending often involves equities, though other fixed-income securities or cash are also widely used as collateral. The main goal is to borrow securities for purposes such as covering short positions or executing trading strategies. In this scenario, the legal title of the loaned securities transfers to the borrower, but the lender retains the right to recall the securities for reasons such as exercising voting rights or responding to corporate actions. When cash is used as collateral in securities lending, the lender will reinvest it and rebate a portion of the returns to the borrower.

Maturity

Securities lending is typically an open-ended process where lenders lend securities without a fixed maturity date, allowing them to be recalled at any time.

When a lender issues a recall to a borrower, the borrower has a fixed period in which to return the securities (typically the date the notice was issued plus the market’s settlement lag).  Often, this deadline isn’t strictly enforced; however, after this period has passed, the lender has the option of executing a ‘buy-in’ to recoup the securities lent.

Sometimes, however, securities lending agreements have defined terms, ranging from a few days to several months. The maturity depends on factors like the type of securities, borrower needs, and market conditions.

Who lends and why

Securities lending plays a crucial role in the financial markets, and understanding the motivations of various participants offers valuable insights into market dynamics.

The primary lenders in this space include institutional investors, asset managers, pension funds, mutual funds, insurance companies, and sovereign wealth funds. Each group engages in securities lending for distinct reasons, all of which are aimed at enhancing returns, managing portfolios, and supporting market functions.

Institutional investors, such as large investment firms and banks, often turn to securities lending to diversify their revenue streams beyond traditional investments. By doing so, they can reduce risk and achieve better portfolio balance. Asset managers also participate in securities lending to improve fund performance. The fees earned from lending securities not only add value for their clients but also contribute to client retention and satisfaction.

Pension funds are motivated by the need to generate additional income to meet their long-term obligations to pensioners. This income helps to offset management fees and enhance the overall efficiency of the fund. Mutual funds similarly seek to boost shareholder value and manage expenses through the revenue generated from lending securities.

Insurance companies utilize securities lending to enhance investment returns, which is essential for meeting policyholder obligations. Additionally, they use the practice to diversify their income streams, thus better managing overall risk.

Sovereign wealth funds, on the other hand, engage in securities lending to support national wealth and economic stability, thus also contributing to broader financial strategies and market functions.

Broader motivations

The broader motivations behind securities lending can be categorized into several key areas.

Income generation is a primary driver, as lenders earn fees from lending out their securities, creating an additional revenue stream and enhancing portfolio returns. The cash collateral received in these transactions can also be reinvested for further income.

Portfolio management is another significant motivation. Securities lending helps improve overall portfolio yields, offset management fees, and manage operational costs. By facilitating market liquidity, securities lending supports efficiency and better price discovery, benefiting all market participants.

Additionally, strategic positioning through securities lending allows lenders to transform collateral to acquire more desirable assets and, in some jurisdictions, reduce capital requirements for regulatory compliance.

In summary, each lender leverages the benefits of securities lending to meet their unique objectives, whether it’s generating additional revenue, enhancing performance, meeting financial obligations, or contributing to broader economic stability.

Who borrows and why

A variety of participants borrow securities for distinct reasons, each driven by their unique motivations and strategies.

Hedge funds and speculators are prominent borrowers to support their short selling strategies. When they anticipate a price decline, they will locate the securities to sell them in the market. If their prediction holds true, they repurchase the securities at a lower price, return them to the lender, and profit from the price difference. Their motivations include profiting from falling stock prices, hedging against market movements, or capitalizing on perceived overvaluations.

Arbitrageurs are another key group of borrowers, driven by the goal of exploiting price discrepancies between related securities. They might borrow shares of a company while simultaneously buying related options or futures contracts to benefit from these price differences. Engaging in various forms of arbitrage—such as convertible bond arbitrage, merger arbitrage, or index arbitrage—they seek risk-free profit opportunities by leveraging inefficiencies across different markets or financial instruments.

Market makers, including broker-dealers and investment banks, borrow securities to facilitate liquidity. These entities need to provide buy and sell quotes for specific securities, ensuring smooth trading and market operations. By borrowing securities, they can meet short-term demand and maintain market liquidity, fulfilling their trading obligations and ensuring smoother market transactions.

Custodian banks and clearing houses often borrow securities during settlement processes to cover temporary shortfalls. If a buyer fails to deliver securities on time, these institutions might borrow them temporarily to avoid settlement failures. This borrowing ensures timely delivery and maintains the integrity of the settlement process, helping to avoid disruptions and ensure smooth market operations.

Institutional investors and pension funds also borrow securities as part of their hedging and risk management strategies. By doing so, they can hedge against various risks, such as interest rate or currency risk, particularly when they hold short positions in related securities. Their primary motivation is to mitigate exposure to market risks and manage their investment portfolios more effectively, ensuring long-term stability and performance.

All participants in the securities lending market share the common goal of optimizing their financial outcomes through the strategic use of borrowed securities.

Types of loans

Securities lending transactions are structured through various types of loans, each defining how the transaction is managed and its associated terms. The nature of the loan influences its flexibility and cost implications. These can be ‘free of payment’ types, where the principal (i.e. the security being loaned) is transferred independently of the collateral – these can be collateralized with cash, or other securities, or vs a cash-pool, or ‘delivery vs payment’ as a rebate type of trade, economically more similar to a repo style transaction.

Open loans represent most securities lending transactions and are characterized by their lack of a fixed maturity date. They can be recalled by the lender or returned by the borrower at any time, offering significant flexibility. However, this flexibility can come with higher fees due to the uncertainty surrounding the duration of the loan.

Term loans, on the other hand, have a specified maturity date. Borrowers must return the securities by this predetermined date, which often results in lower fees compared to open loans. The certainty of the loan period provides a more predictable cost structure for both parties.

Evergreen loans represent a hybrid between open and term loans. They feature a fixed term but automatically renew unless one party decides to terminate the agreement. This structure combines the stability of term loans with the flexibility of open loans, catering to various lending needs.

Callable loans provide another layer of flexibility by allowing the lender to recall the securities before the maturity date under certain conditions. This feature offers a balance between maintaining a term structure and accommodating potential changes in the lending arrangement.

How to lend

Securities lending can be executed through several channels, each offering unique benefits and considerations based on the needs of the asset owner.

Direct lending involves the asset owner (lender) directly lending securities to the borrower. It is typically employed by large institutional investors, such as pension funds, sovereign wealth funds, and mutual funds, who manage their lending activities internally.

Alternatively, asset owners may opt to use lending agents, intermediaries who facilitate the lending process. These agents, which can include custodians, asset managers, or specialized third-party vendors, handle the operational details and ensure compliance with regulatory requirements.

Broker-dealers also play a significant role in securities lending. They act as intermediaries by borrowing securities from lenders and then lending them to their clients, which may include hedge funds or other financial institutions. This model leverages the broker-dealer’s network and expertise in matching lenders with borrowers.

Agency Lending programs offered by financial institutions provide another route for lending. These programs manage the lending process on behalf of their clients, aiming to generate additional income by lending out securities in a controlled and managed manner.

Some securities lending transactions are facilitated through electronic trading platforms or exchanges. These platforms create a marketplace where lenders and borrowers can connect, negotiate terms, and execute transactions, enhancing transparency and efficiency in the securities lending process.

Securities lending transactions undergo complex post-trade lifecycle events, similar to the set of mid-life events that other types of secured funding transactions model. This is necessary to reflect the changes in the economics of the trade, as they are term products, and need to be continually re-valued to reflect changes in the pricing of the underlying assets involved. There is also a complex billing process, typically at month-end that is a standard part of the business workflows involved.

Geographies

The prominence of securities lending activity varies across different regions, and it often correlates with market volatility, M&A activity, and corporate actions. Different regions have varying regulations for short selling and securities lending, with favorable regulations boosting lending activity. Institutional investors, hedge funds, and asset managers also impact demand, and regions with liquidity constraints or collateral requirements rely more on securities lending.

The Americas and Europe remain significant players in the securities lending sector. The US dominates in equity lending, driven by a robust financial market infrastructure and high demand for liquidity. The dynamic nature of securities lending in the US is influenced by factors such as market volatility, regulatory changes, and the ongoing need for collateral optimization. As of 2023, the U.S. securities lending market saw an average daily loan balance of approximately USD 1.3 trillion, with equity lending making up the majority of this figure.

The European market, though facing regulatory challenges such as the Securities Financing Transactions Regulation (SFTR), continues to see substantial activity, with loan balances exceeding USD 500 billion.

APAC’s prominence in securities lending has been a consistent trend due to economic growth, market development, favorable regulatory environments, liquidity needs, and active stock exchanges. Securities finance in the region is gaining traction due to relaxed short-selling restrictions and the need for additional revenue amid low returns. Firms in the region are adopting securities lending and transitioning from on-premise to cloud-based technology solutions, with more buy-side and sell-side firms expected to upgrade their systems in 2024. The region, including key markets like Japan, Hong Kong, and Australia, contributed around USD 300 billion in securities lending balances, reflecting its growing importance despite being smaller than the US and European markets.

The evolving financial landscape necessitates collateral optimization and adaptation to global factors. While the growth trajectory in APAC is likely to continue, regional shifts can occur as market conditions change.

Benefits

Securities lending benefits lenders, borrowers as well as the market.

For lenders, securities lending means extra income through the fees charged for lending their securities, which can help offset management fees and enhance overall fund performance. It also comes with return enhancement, as the receipt of these fees allows them to improve returns on their existing portfolio. Securities lending is also a way to diversify their income sources and help them meet cash-funding needs. It also contributes to increased market liquidity, which can result in tighter spreads and more efficient markets.

For borrowers, securities lending allows them to take short positions and facilitates strategies like arbitrage and hedging, so they can take advantage of market inefficiencies. It also allows for market flexibility: they can gain the ability to take different market views and implement various investment strategies. It also provides a mechanism to cover settlement failures, ensuring smoother market operations.

The market also benefits from securities lending, as it boosts market liquidity, benefiting all participants by narrowing bid-ask spreads. By enabling diverse trading strategies, it contributes to a more dynamic and efficient financial market.

Risks and mitigation strategies

Since securities lending involves several risks, effective risk management is vital for maintaining stability and profitability. Below are the primary risks and ways to mitigate them:

• Counterparty risk arises if the borrower defaults on returning the securities or if the lender defaults on returning collateral. It can be mitigated by conducting thorough due diligence and credit assessments. Counterparty credit limit models can validate securities lending trade activity to ensure that risk does not exceed pre-determined thresholds.
• Collateral risk occurs when the value of the collateral falls below the replacement cost of the lent securities. It can be addressed by implementing comprehensive collateral policies and using ‘haircuts’ to ensure collateral exceeds the value of the lent securities. Participants must manage their trading exposure through the application of margin thresholds and effective management of margin calls.
• Cash collateral risk involves the risk of loss due to fluctuations in reinvested cash collateral. It can be mitigated by setting clear investment guidelines, balancing risk and return, and ensuring sufficient liquidity to quickly liquidate investments if necessary. Counterparty credit limit models can validate securities lending trade activity to ensure that risk does not exceed pre-determined thresholds.
• Settlement risk involves the delivery of securities before receiving collateral. It can be mitigated by ensuring that collateral is received before the loan settles and that securities are returned either before or simultaneously with the release of collateral. Pre-matching, which allows counterparties to match payments in advance of their settlement date, reduces the potential for settlement failures.
• Operational risk relates to errors or disruptions in processes such as settlement and record-keeping. It can be mitigated through robust operational controls, regular audits, and process reviews.
• Concentration risk arises from overreliance on a few borrowers or securities, leading to significant exposure if those parties or assets encounter issues. It can be mitigated by diversifying lending activities across various borrowers and securities.
• Market risk involves the impact of market fluctuations on the value of borrowed securities or collateral. It can be managed by monitoring market conditions, adjusting collateral levels, and employing stress testing.
• Legal risk concerns the adequacy of legal agreements in providing protection in the event of a default. It can be mitigated by ensuring that legal agreements are robust and offer comprehensive protection.
• Ethical and reputational risk involves potential ethical dilemmas or damage to reputation. It can be addressed by considering the ethical implications of lending activities and ensuring that practices align with ESG standards.
• Short seller default risk occurs if short sellers cannot buy back securities due to insufficient collateral. It can be mitigated by rigorously assessing and monitoring collateral levels to cover potential buy-back costs.

By addressing these risks with effective strategies, firms can enhance their stability and resilience in the securities lending market.

Events and trends

Several events and trends highlight the evolving nature of securities lending and its adaptation to regulatory, technological, and market changes.

The T+1 settlement cycle aims to increase efficiency by reducing counterparty risk and improving liquidity. This requires operational adjustments to accommodate the shorter timeframe. In this context, the emphasis of banks such as the Bank of England, the Fed, or the ECB on increased collateralization is particularly relevant. By advocating for higher levels of collateral, central banks support the goal of enhancing security and efficiency across financial transactions, complementing the benefits of the T+1 cycle and addressing the associated risks.

Regulatory changes, such as Dodd-Frank and Basel III, have increased scrutiny of securities lending practices, while the SFTR in Europe enhances transparency in securities financing. The European Supervisory Authorities (ESAs) have established a cyber crisis management framework for cross-border ICT incidents, increasing operational burdens but reducing systemic risk.

The industry is at a crossroads

The securities lending industry stands at a crossroads where technological innovation and market dynamics intersect. Technological advancements—ranging from blockchain and AI to big data analytics and cloud computing—are revolutionizing how securities lending operates, offering new opportunities for efficiency and risk management. However, these advancements come with their own set of challenges, including integration with legacy systems, maintaining data security, and ensuring compliance with evolving regulations.

Looking ahead, the industry must navigate a landscape shaped by ongoing volatility, high interest rates, and shifting geopolitical and environmental factors. The integration of Environmental, Social, and Governance considerations and the potential impact of Central Bank Digital Currencies are poised to further transform the sector. To thrive, firms will need to remain agile, leveraging technological innovations while addressing the inherent challenges and adapting to the evolving market and regulatory environment.

As the securities lending industry continues to evolve, its ability to balance technological advancements with strategic foresight will be crucial. Embracing these changes while managing associated risks will determine the future success and resilience of firms within this dynamic sector.