Securities lending is a financial term used to describe the process of loaning a security, such as a derivative or stock, to another firm or investor. The ownership and title of the security being loaned are transferred to the borrower for the period of the loan, while in exchange the borrower is required to put up some form of collateral, such as a letter of credit, cash or another security.
This type of lending most often takes place between dealers and brokers rather than individual investors. Securities lending is one of the areas of expertise of Domen Zavrl, who has a long history of working within the global financial sector.
Securities lending is used in financial areas such as short selling, fails-driven borrowing, arbitrage and hedging. The PDF attachment explains hedging in more detail.
Reasons for Lending
Many people may ask what the purpose is of lending rather than simply buying or selling a security. There are several reasons why securities lending may be more advantageous than outright sales.
It usually involves some reason why the security in question is only required on a temporary basis. This may be because a bank or financial institution has an agreement to ‘make markets’ in specific types of security. In these cases, there may be incidences where the institution is asked to sell types of securities they do not currently possess. Through securities lending, they can borrow them to make the required sale, usually without having to give lots of notice.
Securities lending can also help institutions that need to access securities quickly – by borrowing rather than buying, they can often gain access much faster.
Finally, borrowing rather than buying can be used to minimise risk, increase profit, or exchange risk for profit in a variety of financial transactions.
The infographic attachment provides some other tips for minimising risk within an investment portfolio.
Collateral
Collateral is required for securities lending, with the borrower being required to put something of equal or greater value than the security being borrowed up as collateral.
Securities loans have a minimum requirement of 102% collateral of the lent security’s market value, plus any accrued interest for debt securities. FDIC regulations state that the minimum collateral required for securities lending is 100% of the value of the security. A clearing broker is typically required to facilitate securities lending transactions – the fee paid by the borrower to the lender is usually split between this broker and the lending party.
The collateral put up by the borrower is most commonly another security or group of securities, although it can also be cash. The technical challenges of this type of transaction often result in the process taking place in two separate stages. Initially the borrower provides cash as collateral in exchange for the security. This cash is then loaned back to the borrower in exchange for securities collateral. In this way the end result of the transaction is cash-neutral, as neither party ends up with anything other than the original security for the borrower and the securities collateral for the lender.
A definition of collateral can be seen in the embedded short video.
Short Selling
One of the areas in which securities lending is most commonly used is in short selling. This involves borrowed securities being sold and bought back, usually within a short space of time. The borrower initiates the transaction because they believe the value of the security is about to fall, so they sell at a high price in order to buy back at a lower price and generate a profit on the deal. Regardless of whether the borrower manages to make a profit, they are still liable for brokerage fees at the end of the agreed lending term.
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