securities borrowing and lending

Also referred to as stock borrow and lending.

securities borrowing and lending is a process through which we can borrow or lend securities through different financial institutions. Borrowers participating in securities lending must provide collateral it can be either in the form of cash or different securities.

on start date/open date securities and collaterals are exchanged between lender and borrower.

on end date/close date securities will be returned by borrower along with securities loan fee and collateral will be returned by lender.

-Borrower must return equivalent securities.

- Either on Open/Demand meaning whenever the Lender recalls the securities.

- Or on a specified future date then called as Term.

-Similarly Lender must return equivalent collateral to borrower.

**Note: the term equivalent securities or collateral refers to

-        Identical type

-        Nominal value

-        Description

-                    Amount

The reason why equivalent securities is because the original securities are likely used by the borrower.

LENDERS FEE

-Lenders earn fees on lending securities. Which is on the value of securities loaned.

- Also referred to as Rental fee/ Sec Lending fee/ Stock Loan Fee.

-Size of the fee depends on the following factors.

                                               - Depends on the collateral given (or posted) by

                                                   Borrower. If collateral value high fee is low and

                                                    vice versa.

-        Types of securities borrowed (Scarcity factor: low supply but very high demand)

-        Borrower’s credit rating inversely proportional to fees.

-        Term of contract whether it is Open high rental fee/ Fixed low rental fee.

-        Market conditions.

When Non- cash collateral is posted

-         If non-cash collateral is posted then Borrower pays ‘RENTAL FEE’.

-        Rental fee is denoted in terms of ‘Basis points’ or ‘bps’.

-        Basis point is 1/100th of %.

-        For Eg Value of securities loaned is $10,000,000,

                                rental fee charged is 50 bps

                                then end of contract  the rental fee is $50,000.

When Cash collateral is posted

-      If the cash collateral is posted , then borrower pays Rental fee, but Lenders pays ‘Rebate Interest’.

-     As per regulations if borrower posts cash collateral, then the lender is re invest the cash in the market and interest earned on this cash, a part of it has to be returned to the borrower which is called Rebate interest , which the lender is obligated to pay the borrower.

-    Lender deducts the rebate interest from the re investment rate and that becomes the rental fee.

                                     Types of Securities Loaned

-        Equities

-        Bonds: Govt ,Corporate, Supranational .

*Supranational Bonds: bonds issued by Supranational Entities. Entities that are made of 2 or more central govt, with the purpose of promoting economic development of the member countries, like U.N,IMF etc-        MBS or ABS

-        Hybrid securities like Convertibles.

-        DR’s

-        Money Market instruments like CPs, T-bills.

Securities loaned can fall under two categories

1)    General Securities

-        Very liquid, widely available.

-        Lenders charge lower Rental Fee.

-        Borrowers can post collateral as per their decision.

2)    Specials

-        Rare, hard to borrow.

-        Lenders can demand premium for rental fee.

-        Borrowers are more flexible in posting collateral as per lender’s requirement.

                                                     COLLATERAL

-        To protect the lender the borrower must provide collateral.

-        Lenders generally demand collateral that is

·       Highly liquid

·       Has low credit risk

·       Has low market risk

-        Collateral can be Cash or Non- Cash

-        **Lenders requires Collateral Value > Securities loaned valued.

-        The amount by which the securities is over collateralized is called ‘ Hair cut or Lender’s margin’.

-        For Eg  Value of securities loaned is $10,000,000.

                                                Margin: in same ccy 102%

                                                               in Foreign ccy 105%

-        Lenders margin is determined by following factors

·       Collateral quality high then lender’s margin lower and vice versa

·       Borrower risk or credit rating

·       Open lender margin more/Term is low

-       Margin level is valued on a daily basis to ensure loan is sufficiently collateralized.

-       If the market value of the collateral decreases the Borrower will have to post further collateral.

 Legal Ownership of the Securities

-      When securities are loaned absolute ownership passes to Borrower and lender receives ownership in case of non-cash collateral.

-      Borrowers are entitled to dividends( shares) and interest payments( Coupons on bonds) that are borrowed.

-      However they will have to compensate the Lender on loss of income.

-      Lenders surrenders the voting rights and corp actions.

-      Lenders however can recall the loaned securities if they wish to exercise voting rights or respond to corporate actions.

MARKET PARTICIPANTS & PRACTICES

I)     Securities Lenders

-        Are institutional investors with large securities portfolios.

Eg: MFs, HFs ,Pension Funds, Insurance Companies, Banks, Sovereign wealth funds(SWFs),Central banks.

-        Securities lender follow 2 strategies mentioned below

a)    Value Lending/ Intrinsic Lending

Lends relatively scare & high cost securities ( Specials),thus capturing premium on rental fee. High returns but few opportunities to lend.

b)    Volume Lending / General Securities Lending

Lends are volume of securities regardless of scarcity factor. Rental fees are lower but more lending opportunities.

Accounts for majority of sec lending.

 -        Lending  Revenue

a)    Fee Income

·       Lenders earn rental fee.

·       High rental fee can be charged if lender on open contract and lower on closed.

·       Higher rental fee can be charged if lender offers exclusive borrowing rights.

·       Higher rental fee can charged of lenders are flexible on receiving any type of collateral.

b)    Collateral Reinvestment income: Can earn income by reinvesting of cash collateral in high quality, short term investments.

c)     Sources of Raising Cash: Cash collateral received can sometimes be a cheaper method of sourcing funds.

II)              Securities Lending Agents

-        Smaller number of lenders lend directly to borrowers, this is also called as ‘Principal to Principal Lending’.

-        Lenders would then retain all associated revenue but the downside is lender would have to invest in resources & infrastructure to support lending program from both FO and BO perspective.

-        Vast majority of sec lenders use Custodians or Tri-Party Specialist with revenues split b/w sec lender and lending agents.

Types of Sec Lending Agents

1)    Custodian Model

-        Helps Sec lenders negate admin costs, transaction costs etc.

-        Borrowers might go to custodians cause they have large pool of securities that are liquid.

-        Custodian pools all Sec lenders securities and has a queue system to allocate to borrowers.

-        Collateral received is pooled and invested.

2)    Third Party or Tri-Party Agents.

-        TPA specializes in Sec lending.

-        Do not pool together Sec lenders securities.

-        Negotiates with borrowers on behalf of lenders.

-        Collateral collected is reinvested in short term high return markets.

Roles of Sec Lending Agents

In return for getting part of the revenue that is generated lending agents also provide the following services.

I)                Access to the market: As they have a presence in the market they can inform the lenders of the market demands and opportunities.

II)              Supply Aggregation: Because agents typically have many lenders on their books, they can supply securities in large numbers to borrowers.

III)            Collateral Management: Manage receipts of collateral on a daily basis, ensuring client loans are secured & appropriately margined.

IV)            Regulatory Compliance: Ensure Lenders are in compliance with relevant regulatory obligations.

V)              Income Collection: Collecting rental fee, dividends, and coupons.

VI)            Indemnification: May provide protection to lenders against certain risks such as default when collateral is insufficient to cover the loss.

*Lending agents are responsible to recall borrowed securities on time in case if lenders wanting to sell or exercise voting rights or corporate actions.

I)                Securities Borrowers

-        Sec borrowers are typically large banks and Hedge funds.

-        Borrowers are attracted to lenders that

·       Have large portfolio of securities( specially scare securities)

·       Don’t recall securities quickly.

Why Borrowers Borrow?

1)    Market Making

-        Banks and broker dealers are market makers that required to make Bid/Ask px on securities.

-        Because their sec inventory is low and they don’t hold every security in the market, so they borrow to ensure two way quotations.

2)    Failed Settlements

-        To prevent failed settlements

3)    Collateralization of other Transactions

-        Because increase in regulatory requirement of the use of CCPs.

4)    Dividend Arbitrage

-        is a trading strategy that involves purchasing put options and stock before the ex-dividend date and on ex date exercising the   the put.