Securities Lending – a Quick Overview
Securities lending is an interesting topic. If you are on a streak of learning about securities or would simply like to freshen your knowledge – we’ve got you covered. Have a look at our guide on securities lending.
What is Securities Lending?
Securities lending means loaning a stock, derivative or other security to an investor or firm. It requires the borrower to put up a collateral. This can be cash, security or a letter of credit. If a security is loaned, the title and the ownership are also transferred to the borrower.
How Does It Work?
In general, securities lending happens between brokers and/or dealers. Securities lending usually doesn’t involve individual investors. A securities lending agreement (known as loan agreement) has to be completed to finalize the transaction. This specifies the terms of the loan, such as duration, lender’s fees and the nature of the collateral.
Let’s address the collateral. Lenders of valuable assets usually ask for collateral, which provides a kind of insurance for the lender. For securities lending, the collateral may be cash or more commonly other securities. According to FDIC regulations, borrowers should provide a collateral that’s worth at least 100% of the security’s value. The collateral also depends on the volatility of the security.
Typical securities lending requires clearing brokers. They facilitate the transaction between the borrowing and lending parties. The borrower pays a fee to the lender for the shares. This fee is split between the lending party and the clearing agent.
Why Borrow a Security?
Now that you know the definition of securities lending, let’s address the obvious question. Why would you do it, instead of just buying a security?
In some cases, a security is only needed temporarily. It can be just for one day or a few weeks. So, it is often cheaper, quicker or less risky to borrow a security instead of buying it. The motives differ depending on the type of organization. For example, some banks have agreements to “make markets” in certain securities. This basically means they have to be ready to buy and sell a security to any of their counterparties. These could be pension funds or asset managers. Banks must prepare for this. If they need to sell some securities that they currently don’t have, they can borrow them at short notice.
Other Use Cases
This example is not the only one. Many different financial strategies rely on borrowing a security temporarily. Securities lending is also used in short selling. This is a process where an investor borrows securities to immediately sell them. The goal of this is to make a profit by selling the security and buying it back later at a lower price. Since ownership transfers temporarily to the borrower, the borrower is liable to pay any dividends out to the lender. In such cases, the lender receives the previously determined fees and also has the security returned at the end of the transaction. So, the lender can enhance their returns through the fees. The borrower benefits from profits that come with shorting.
In addition, securities lending is also used in processes like trading, arbitrage (making riskless profit from unjustified price differences) and hedging (reducing risks). In all of these scenarios, the benefit to the securities lender is either to earn a small return on securities currently held in its portfolio or to possibly meet cash-funding needs.
Now that you know what securities lending is, why not continue learning? Head over to our security token platform and start exploring!