Securities Lending
Securities lending describes the market practice by which, for a fee, securities are transferred temporarily from one party, the lender, to another, the borrower; the latter is obliged to return them either on demand or at the end of any agreed term. This section on securities lending aims to be a general overview. Readers should refer to Mark Faulkner's highly respected introduction to securities lending book from which much information is based. You can download the paper from the useful links area on the right.
The simplest example of securities lending is Borrow vs Fee. This is a straight borrowing of bonds vs payment of a fee to the lender. The advantage of this type of trade is that it does not involve cash management. Hence counterparties with restrained back office department may be more inclined to perform this type of transaction.
The Borrow/Loan vs Cash transaction is similar in almost all respects to a classic repo/ reverse repo. A different legal agreement is necessary and while the majority of trades settle DVP, not all do. As with a repo agreement the legal title of the bonds changes hands under a securities lending agreement. As such the borrower is able to sell any borrowed bonds into the market as long as he/she is able to rebuy them at a later stage to return to the lender. The main reason for carrying a Borrow/Loan vs. Cash trade instead of a straight fee trade is because there is no settlement risk in the former type of transaction. This is because there is collateral flow on either side of the trade. Hence, should either side fail, there is the security of cash or collateral for the counterparty being failed to.
The revenue generated from cash-collateralised securities lending transactions is derived from the difference or 'spread' between interest rates that are paid and received by the lender.
The other types of securities lending involve transactions collateralised with other securities or assets. This is generally known as Bonds Borrow/Collateral Pledged transactions and occurs mainly with special collateral as it is being driven by the dealer needing the particular bond. The institution lending the bonds does not want to receive cash as collateral. Usually, cash-rich institutions entering into such trades would only have to reinvest any cash generated.
A fee is paid to the lending institution. The agreement of a fee is reached between the parties and would typically take into account:
- demand and supply
- collateral flexibility - the cost to a borrower of giving different types of collateral varies significantly, so that they might be more willing to pay a higher fee if the lender is more flexible
- the size of the manufactured dividend required to compensate the lender for the post-tax dividend payment that it would have received had it not lent the security
- term of the transaction
The eligible collateral will be agreed, as will other key factors including the notional amounts, the initial margin and the maintenance margin just as in a repo transaction. For efficiency most margin agreement details are agreed in advance of a new trading relationship and included in an addendum of the SLB agreement, thereby saving time. Non cash collateral pledged includes government and corporate bonds, convertible bonds, equities, certificate of deposits drawn on institutions of a specified credit quality, warrants and letters of credit (LOC) from banks of a specified credit quality. The last transaction involving LOCs is rare in the fixed income market because banks would typically charge 15-40 basis points for this facility. The non-cash collateral pledges are more predominant in Europe while the US uses more cash.
Here is an example of a Borrow Bonds/Collateral Pledged transaction.
| Securities lending: borrow bonds/collateral pledged transaction calculation | |
|---|---|
| UBS borrows DKK 300 million Danish government bond 8% 11/01 | |
| Collateral pledged: | Danish Govt Bond 7% 11/07 |
| Term: | 1 month (Jan 22 to Feb 22) |
| Fee: | 40 basis points |
| Market price of Danish Govt Bond 8% 11/01 (incl. accrued interest | = 112.70 DKK 300 million nominal = DKK 338,100,000 |
| Market price of Danish Govt Bond 7% 11/07 (incl accrued interest) | = 102.55 Amount of collateral pledged = 338,100,000/1.0255 = 329,692,832.76 |
| Fee payable | = 338,100,000 x 31/360 x 0.4/100 = DKK 116,456.67 |
