What Is Securities Lending?
Securities lending is the act of loaning a stock, derivative or other security to an investor or firm. Securities lending requires the borrower to put up collateral, whether cash, security or a letter of credit. When a security is loaned, the title and the ownership are also transferred to the borrower.
- Securities lending is the act of loaning a stock, derivative or other financial instrument to a broker for trading in exchange for collateral.
- Securities lending is important in several trading activities, such as short selling, hedging, arbitrage, and fails-driven borrowing.
Understanding Securities Lending
Securities lending is generally conducted between brokers and/or dealers and not individual investors. To finalize the transaction, a securities lending agreement, known as loan agreement, must be completed. This sets forth the terms of the loan including duration, lender’s fees and the nature of the collateral.
According to FDIC regulations, borrowers should provide at least 100 percent of the security's value as collateral. Collateral for securities also depends on its volatility. The minimum initial collateral on securities loans is at least 102 percent of the market value of the lent securities plus, for debt securities, any accrued interest.
Typical securities lending requires clearing brokers, who facilitate the transaction between the borrowing and lending parties. The borrower pays a fee to the lender for the shares and this fee is split between the lending party and the clearing agent.
Benefits of Securities Lending
Securities lending is important to short selling, in which an investor borrows securities to immediately sell them. The borrower hopes to profit by selling the security and buying it back later at a lower price. Since ownership has been transferred temporarily to the borrower, the borrower is liable to pay any dividends out to the lender. In these transactions, the lender is compensated in the form of agreed-upon fees and also has the security returned at the end of the transaction. This allows the lender to enhance its returns through the receipt of these fees. The borrower benefits through the possibility of drawing profits by shorting the securities.
Securities lending is also involved in hedging, arbitrage and fails-driven borrowing. 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.
Understanding Short Selling
A short sale involves the sale and buyback of borrowed securities. The goal is to sell the securities at a higher price, and then buy them back at a lower price. These transactions occur when the securities borrower believes the price of the securities is about to fall, allowing him to generate a profit based on the difference in the selling and buying prices. Regardless of the amount of profit, if any, the borrower earns from the short sale, the agreed-upon fees to the lending brokerage are due once the agreement period has ended.
Rights and Dividends
When a security is transferred as part of the lending agreement, all rights are transferred to the borrower. This includes voting rights, the right to dividends and the rights to any other distributions. Often, the borrower sends payments equal to the dividends and other returns back to the lender.
Example of Securities Lending
Suppose an investor believes that the price of a stock will fall from its current price of $100 to $75 in the near future. The stock is not very volatile and generally trades in defined ranges. In order to profit from her thesis, she borrows 50 shares of the company from a securities firm by putting up a cash collateral of $5000. The investor purchases the shares back at a reduced price after the stock's price falls to the predicted price and receives a stock loan rebate from the lender.