Securities lending
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In finance, securities lending or stock lending refers to the lending of securities by one party to another. The terms of the loan will be governed by a "Securities Lending Agreement", which requires that the borrower provides the lender with collateral, in the form of cash, government securities, or a Letter of Credit of value equal to or greater than the loaned securities. The agreement is a contract enforceable under relevant law, which is often specified in the agreement.
As payment for the loan, the parties negotiate a fee, quoted as an annualized percentage of the value of the loaned securities. If the agreed form of collateral is cash, then the fee may be quoted as a "short rebate", meaning that the lender will earn all of the interest which accrues on the cash collateral, and will "rebate" an agreed rate of interest to the borrower. Key lenders of securities include mutual funds, insurance companies, pension plans and other large investment portfolios.[1]
Securities lending is an important means of eliminating "failed" transactions as well as enabling hedge funds and other investment vehicles to sell shares short.[2]
Market size
Until the start of 2009 Securities Lending was only an over-the-counter market, so the size of this industry was difficult to estimate accurately. According to the industry group ISLA, in the year 2007 the balance of securities on loan globally exceeded £1 trillion.[3]
An example
In an example transaction, a large institutional money manager with a position in a particular stock would allow those securities to be borrowed by a financial intermediary, typically an investment bank, prime broker or other broker-dealer, acting on behalf of one or more clients; after borrowing the stock, these clients could sell it short. The short seller would like to buy the stock back at a lower price (which would create a profit). Once the shares are borrowed and sold, it generates cash from selling the stock. That cash would become collateral for the borrower. The cash value of the collateral would be marked-to-market on a daily basis so that it exceeds the value of the loan by at least 2%.
Often a bank serves as the lending agent, receiving the cash collateral and investing it until it must be returned. The income from the reinvested cash collateral is divided by paying the borrower a rebate and then dividing the remaining amount between the securities lender and the agent bank. This allows major investment funds to earn incremental income on their portfolio holdings. Where the lender is a pension plan, the transaction may need to comply with various exemptions under the Employee Retirement Income Security Act of 1974 (ERISA).[4]
Legalities
Securities Lending is legal and clearly regulated in most of the world's major securities markets. Most markets mandate that the borrowing of securities be conducted only for specifically permitted purposes, which generally include;
- to facilitate settlement of a trade,
- to facilitate delivery of a short sale,
- to finance the security, or
- to facilitate a loan to another borrower who is motivated by one of these permitted purposes.
When a security is loaned, the title of the security transfers to the borrower. This means that the borrower has the advantages of holding the security, as they become the full legal and beneficial owner of it. Specifically, the borrower will receive all coupon and/or dividend payments, and any other rights such as voting rights. In most cases, these dividends or coupons must be passed back to the lender in the form of what is referred to as a "manufactured dividend".
The initial driver for the securities lending business was to cover settlement failure. If one party fails to deliver stock to you it can mean that you are unable to deliver stock that you have already sold to another party. In order to avoid the costs and penalties that can arise from settlement failure, stock could be borrowed at a fee, and delivered to the second party. When your initial stock finally arrived (or was obtained from another source) lender would receive back the same number of shares in the security they lent.
The principal reason for borrowing a security is to cover a short position. As you are obliged to deliver the security, you will have to borrow it. At the end of the agreement you will have to return an equivalent security to the lender. Equivalent in this context means fungible, i.e. the securities have to be completely interchangeable. Compare this with lending a ten euro note. You do not expect exactly the same note back, as any ten euro note will do.
As a result of Regulation SHO, adopted by the SEC, short sellers typically must either possess the shares they are selling short or have a right to obtain them in order to cover the short sale.
Securities lenders
Securities lenders, often simply called sec lenders, are institutions which have access to 'lendable' securities. This can be asset managers, who have many securities under management, custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder's custodian. The international trade organization for the securities lending industry is the International Securities Lending Association. According to a June 2004 survey, their members had euro 5.99 billion worth of securities available for lending. In the US, the Risk Management Association publishes quarterly surveys among its (US based) members. In June 2005, these had USD 5.77 billion worth of securities available.
Typical borrowers include hedge funds and the proprietary trading desks of investment banks.
Term in investment banking
In investment banking, the term "securities lending" is also used to describe a service offered to large investors who can allow the investment bank to lend out their shares to other people. This is often done to investors of all sizes who have pledged their shares to borrow money to buy more shares, but large investors like pension funds often choose to do this to their unpledged shares because they will receive interest income. In these types of agreements, the investor still receives any dividends as normal, the only thing they cannot generally do is to vote their shares.
Term in private securities-collateralized lending
The term "securities lending" is sometimes used erroneously in the same context as a "stock loan" or individual "securities-collateralized loan". The former refers to the actual lending typically of banks or brokerages to other institutions to cover short sales or for other temporary purposes. The latter is used in private or institutional securities-backed loan arrangements across a wide spectrum of securities. In recent years, FINRA has cautioned all consumer to avoid nonrecourse transfer-of-title stock loans, but they enjoyed a brief popularity before the SEC and IRS came to shut almost all such providers down between 2007-2012, reclassifying nonrecourse transfer-of-title title stock loans as fully taxable sales at inception (See FINRA advisory link below). Today, it is widely accepted that the only legally valid consumer lending programs involving stocks or other securities are those in which the stocks remain in the client's title and account without sale through a fully licensed and regulated institution with membership in the SIPC, FDIC, FINRA and other mainline regulatory organizations, with their own audited financial statements. These are usually in the form of securities-based credit lines.
Other alternatives include working with a reputable provider of securities loans willing to provide references, track record of successful transactions completed, and process of funding the loans and returning the collateral. In 2011, the Financial Industry Regulatory Authority (FINRA) issued an investor alert on stock-based loan programs.[5] In the alert, FINRA recommended investors ask several questions, including: 1) What happens to my stock once I pledge it as collateral? (FINRA states that securities should never be sold to fund the loans); 2) Does the lender have audited financials? (FINRA noted that any publicly traded major brokerage/bank that reports will need to have audited financial data available for investors); and 3) Is the institution managing the loan and accounts fully licensed and in good standing?
Currently such institutional credit line programs are available only through long-standing depository relationships with institutional brokerages and their banking arms, and typically come with large depository minimums. However, there are a few securities-based credit line programs currently available in the general market that allow access at competitive rates and terms without such advance depository or client relationships, and these can be easily found by searching on Google with "credit line no title transfer or sale to fund" and similar terms.
See also
References
- ^ Lemke, Lins and Smith, Regulation of Investment Companies §8.02[1] (Matthew Bender, 2013).
- ^ Lemke, Lins, Hoenig and Rube, Hedge Funds and Other Private Funds, Chapter 6 (Thomson West, 2012).
- ^ "An Introduction to Securities Lending. 1 August 2005, ''Executive Summary'', Page 8" (PDF). Retrieved 2012-05-18.
- ^ Lemke and Lins, ERISA for Money Managers §§2:113 - 2:114 (Thomson West, 2013).
- ^ http://www.finra.org/investors/protectyourself/investoralerts/tradingsecurities/p123719