Securities Lenders
This section on securities lending uses some of the work done by Mark Faulkner's highly respected introduction to securities lending which you can download from the useful links area on the right. Securities lending is the temporary transfer of a security by its owner to another investor or financial intermediary. Once the securities have settled, the title and voting rights are transferred to the borrower, who can sell or re-lend the borrowed securities during the life of the loan. In return, the borrower agrees to return the loaned securities, secure the loan with collateral of equal or greater value than the loaned securities, and pay any user fees (implicit or explicit), and remit to the lender any dividends, coupon interest or other distributions that occur during the time the securities are on loan.
Who participates?
Borrowers
Borrowers are usually broker-dealers, investment banks, prime brokerage units and hedge funds. Generally, they borrow securities to facilitate market transactions, such as covering shorts, preventing fails, and facilitating trading strategies such as risk arbitrage and pairs trading. They might also borrow securities to engage in tax arbitrage and other financing activities.
Lenders
Lenders are large institutional investors. These include public and private pension funds, insurance companies, mutual funds and investment managers. Lenders engage in securities lending as a means of generating additional revenue, which they can use to defray expenses or cover fund-specific projects. They have assets in the form of equities and fixed income securities. They will most commonly participate in the market in one of two ways, either directly or indirectly through an agent.
Direct Lenders
Direct Lenders tend to be large institutional investors such as Pension Plans, Insurance and Life Companies.
Agent Lenders
Agent Lenders will act for any beneficial owner regardless of size, but where the beneficial owner does not wish to participate directly, for reasons of cost or size. Agent Lenders will tend to be Global Custodians or Asset Managers participating on behalf of a large number of clients.
The Borrowing Motivation
The most common reason to borrow securities is to cover a short position - using the borrowed securities to settle an outright sale. But this is rarely a simple speculative bet that the value of a security will fall so that the borrower can buy it more cheaply at the maturity of the loan. More commonly, the short position is part of a larger trading strategy, typically designed to profit from perceived pricing discrepancies between related securities.
EXAMPLES:
- Convertible bond arbitrage: buying a convertible bond and simultaneously selling the underlying equity short.
- 'Pairs' trading: seeking to identify two companies with similar characteristics, whose equity securities are currently trading at a price relationship that is out of line with the historical trading range. The apparently undervalued security is bought, while apparently overvalued security is sold short.
- Merger arbitrage: selling short the equities of a company making a takeover bid against a long position in those of the potential acquisition company.
- Index arbitrage: selling short the constituent securities of an equity price index (e.g.: FTSE 100) against a long position in the index future (e.g.: FTSE 100 contract on LIFFE)
Short selling also arises as a result of failed settlement (with some securities settlement systems arranging for automatic lending of securities to prevent chains of failed trades) and where dealers need to borrow securities in order to fill customer buy orders in securities where they quote two-way prices.
Not all securities lending is motivated by short selling. Financing drives many transactions: the lender seeks to borrow cash against the lent securities, whether using repo, buy/sell backs or cash-collateralised securities lending.
Another large class of transactions not involving a short comprises those motivated by lending in order to transfer ownership temporarily, an arrangement which can work to the advantage of both lender and borrower.
EXAMPLE: A lender may or may not be subject to withholding tax on dividends or interest. Similarly a borrower's tax status may influence taxation payments. Such differential in cost and benefits can induce trade motivation across borders. It is highly recommended that all clients consult their own tax advisors and understand their respective tax jurisdiction prior to any trading.
