Most institutional investors now participate in a securities lending program, whether directly or indirectly. Although securities lending income typically constitutes no more than a few basis points, given volume, the absolute dollar amount can be significant. In some cases, it can even pay for a large portion of the expenses associated with running an investment program. Securities lending income, however, is not a free lunch. The risks cannot be ignored, however small they may be. Minimizing risk should take precedence over maximizing returns.
Securities lending is a temporary collateralized loan of assets from a portfolio (lender) to a borrower. A contract between borrower and lender governs all elements of the loan. It enables beneficial owners the ability to finance their securities inventory, thereby generating incremental income. There are many reasons for borrowing securities. Some include to avoid trade settlement failure (securities sold but not available for delivery). Or to cover short trading positions. Or to support hedging, derivative, and arbitrage strategies. In other cases, it is to support Broker/Dealer efforts to match book funding. The borrower posts collateral equal to at least 100% of market value of lent securities. Collateral can take the form of cash, other securities, or letters or credit. The transfer of loaned securities and collateral constitutes a pledge. The lender retains economic benefits of the security; however, proxy voting is transferred from lender to borrower. Lender can sell securities at any time, which subject to timely advice, will be returned within normal settlement periods.
Firms engaged in this business often work with others who select approved borrowers that meet internal credit standards. They also broadcast the portfolio on an aggregate basis to identify lending opportunities. They negotiate loans, process lending transactions, and manage collateral. Routine functions include the daily mark-to-market of loaned securities and collateral as well as billing, reconciliation, recordkeeping, and reporting.
WHAT IS SECURITIES LENDING?
Market participants such as broker-dealers and hedge funds borrow securities to execute trading strategies that may include short sales or arbitrage trades. Owners of securities lend them to those who need to borrow them, in exchange for reasonable compensation. Intermediaries such as custodial banks and third-party securities lending agents help facilitate the securities lending process. Lending Agents are appointed by the lender to manage the lending decision and most are large custodians.
Many institutional investors engage in securities lending programs with the objective of generating additional revenue by taking on exceptionally low levels of risk. There is a securities lending market for both equity and fixed income securities. The industry continues to develop as new participants are attracted and new technology serves to facilitate this growth.
Investors participate in securities lending programs either directly for their separate account portfolios (portfolios that hold individual securities in the name of the investor), or indirectly through commingled or mutual funds (where the investor owns units of the fund, not the individual securities, which are owned by the fund). In the latter case, the investor has no control over the securities lending program, as the lending guidelines are determined by the fund companies.
HOW DOES IT WORK?
There are two basic ways to structure a securities lending program:
In a principal-based securities lending program, the investor agrees to lend the entire portfolio (or specific portions) to a single borrower on an exclusive basis. Major borrowers are securities dealers and banks, ranging from US Broker & US Gov’t security dealers to universal banks. So, essentially, anyone in the business of dealing in securities is a potential borrower. Many borrowers may not be borrowing just to meet their own proprietary trading needs, so they act as intermediaries by relending to the ultimate borrower, or end-user. The end-users typically are hedge funds, abitrageurs or other institutional investors. In exchange for exclusive rights, the borrower will typically guarantee either a minimum portfolio percentage on loan, or some minimum revenue target.
U.S.-based institutional investors predominantly participate in agency-based securities lending programs. In this case, a lending agent attempts to lend the portfolio on a best-efforts basis. The lending agent could be the custodial bank, or a third-party agent. The exhibit provides a schematic of the basic steps in a program.
- The lending agent finds a borrower for the securities. The borrower deposits collateral – either cash or non-cash – with the lending agent. The loan is typically collateralized at around, depending on markets, 102% for domestic securities and a bit higher for riskier for non-U.S. securities. The collateral is marked-to-market daily. In the case of cash collateral, the lending agent negotiates the interest rate to be paid on the collateral to the borrower of securities, referred to as the rebate rate. In the case of non-cash collateral, the lending agent negotiates a fee to be paid by the borrower.
- The lending agent invests the cash collateral in capital markets with the goal of earning something over and above the rebate rate.
- When the loan is no longer required, the borrower returns the securities to the lending agent. The close-out of the loan may occur because the borrower no longer needs the security, or because the owner needs the security returned due to a sale by the portfolio manager. At this stage, the lending agent returns the cash collateral plus the agreed-upon rebate rate to the borrower.
- The difference between the return earned on the cash collateral investment and the rebate rate is the gross spread. The lending agent retains a portion of the gross spread as its fee and credits the remainder to the owner of the securities.
REVENUES DEPEND ON:
- Lendable portfolio value. The value of the securities available for lending. Non-lendable investments include private equity, real estate, and investor shares in commingled/mutual funds.
- Type of securities. Small-cap domestic stocks, international stocks and treasuries are in greater demand in the securities lending market than large-cap domestic stocks and corporate bonds.
- Percentage of portfolio on loan. The greater the proportion of the portfolio on loan, the greater the potential for securities lending revenue. The average percentage of the portfolio on loan depends on the type of securities in the portfolio, as well as the ability of the securities lending agent to loan them out.
- Rebate rate. The rate of interest paid to the borrower of a security on the collateral. In general, the rebate rate negotiated will be low if the security being lent is in short supply.
- Return on collateral investment. The higher the return on the collateral investment, the greater the revenue generation.
- Spread. Difference between the return on collateral investment earned and the rebate rate paid.
The gross return from a securities lending program can be expressed as follows:
Gross Securities Lending Revenue = Lendable Portfolio Value x Percentage on Loan x Spread
The securities lending agent typically retains 15% to 35% of the gross revenues from securities lending programs as its fee. The balance is the net revenue to the investor from securities lending. The split typically depends on the securities lending revenue-generating potential of the portfolio.
RISKS IN A SECURITIES LENDING PROGRAM
Key risks include:
- Collateral Investment Risk. The greatest risk in a securities lending program comes from collateral investments. Even aggressive collateral investment guidelines are unlikely to add more than a few basis points annually to the return of the overall fund, while the downside, can be meaningful.
Collateral investments typically take on duration risk and credit risk to enhance the securities lending revenues. Security loans can be considered as overnight transactions that are rolled over daily. Collateral is typically invested in instruments with longer maturities to try to capitalize on higher yields (assuming an upward-sloping yield curve), creating an asset/liability mismatch. Collateral losses can result if interest rates rise (interest rates and the value of fixed-income securities are inversely related – a rise in rates causes the market value of a bond to decline, and vice versa). Returns are also enhanced by taking on some credit risk. Losses can occur if spreads widen, the issuer of the fixed-income paper is downgraded, or the issuer defaults. Securities lending can be viewed in a sense as fixed-income leverage.
- Borrower Risk or Counterparty Risk. Borrower risk is the risk that the borrower does not return the borrowed securities. Borrower risk can be controlled by approving only high quality borrowers, setting individual borrower limits, and regularly monitoring the borrowers. Further protection is available to the lenders in the form of the collateral deposited by the borrowers (102% to 105%) which is marked-to-market on a daily basis. Indemnification against borrower default is typically offered by the lending agent or can be negotiated in a securities lending program. In a principal securities lending program, the entire counterparty risk is with a single borrower, unless the portfolio has been split into various pools and distributed among various principal borrowers to achieve diversification.
- Operational Risk. Securities lending involves a number of moving parts. Collateral has to be collected in exchange for lending securities; collateral has to be marked-to-market daily; compliance of borrower limits have to be monitored; corporate actions on securities need to be tracked; securities lent have to be recalled when sold, and so on. Securities lending agents should have processes in place to manage each aspect of a securities lending program to minimize the operational risk.
It is common industry practice for the lending agent to earn a portion of the securities lending revenues but not share in the losses on collateral investments. This asymmetric reward structure could motivate the lending agent to take undue risks. In the past securities lending programs have incurred losses as a result of an increase in interest rates. In most cases, the lending agent covered the losses even though it was contractually not obligated to do so. Also, some securities lending programs have incurred losses due to issuer defaults in the collateral investments.
Investors can certainly lose money by participating in securities lending programs, but losses have been few and far inbetween. Although the reward structure for the agent is not necessarily aligned with the interest of the investor/lender, in general the business risk from losses in a securities lending program have served as a check on lending agents. Collateral investment risk can be virtually eliminated by investing in duration-matched government securities/repurchase agreements, but this can significantly reduce (if not eliminate altogether) the revenue-generating potential, which might make a securities lending program unviable for many institutional investors. Most lending agents offer a choice of collateral investment pools with different risk/return characteristics. The collateral investment pools attempt to control risk by approaches such as evaluating each credit, investing in high-quality instruments, limiting the maximum duration and maturity, and limiting the maximum investment in the paper of a single issuer.
Large institutional investors can also specify that their collateral be managed separately according to guidelines tailored to their needs. If the collateral to be managed is not substantial, though, diversification may not be achieved to the same extent as in the collateral investment pools.
A carefully structured securities lending program can help offset some plan expenses. Investors need to determine the amount of risk they are willing to take and it is best to be conservative. The objective in a securities lending program should be to minimize the risk of loss, not to maximize income.