Securities lending

In finance, securities lending involves a transfer of securities (such as stock shares or bonds) to a borrower, who gives the lender collateral (which can be  shares, bonds or cash). The borrower pays the lender a fee each month for the loan and is contractually obliged to return the securities on demand. In the U.S. primary security lenders include large institutional investors such as mutual funds, pension plans, insurance companies, and endowments; the main borrowers of securities include broker-dealers, hedge funds, and proprietary trading desks of broker-dealers. When common stocks are lent, the borrower has the right to receive stock dividends and vote proxies for the duration of the transaction.

The parties involved in securities lending
The principle parties involved in security lending are the lender, the borrower, and in most instances, the agent lender.

Lenders are typically large scale investors, such as pension funds, insurance companies, collective investment schemes and sovereign wealth funds. These investors would normally employ an agent (such as a custodian) to arrange, manage and report on the lending activity.

Borrowers are typically large financial institutions, such as investment banks, market makers and broker dealers. Hedge funds are among the largest borrowers of securities, but they will borrow through investment banks or broker dealers rather than directly from the investor.



Lender motivations for lending securities can include:
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 * Offsetting the expenses of managing and administering an investment portfolio;
 * Maximizing overall portfolio performance;
 * Foreign investors employing dividend arbitrage to reduce effective tax rates on dividend income.

Borrower motivations for borrowing securities can include:
 * Covering short positions;
 * Hedging investment positions;
 * Arbitrage;
 * Gaining voting rights.

In most instances, security lending is transacted through an agent lender (often a custodial bank) who, for a negotiated fee, administers the lending program and often reinvests the collateral cash. . The agent lender may be an independent entity, or an affiliate of the lender.

The lender may pass along all, or a portion of net security lending income to the fund portfolio.

Security lending transaction
A typical security transaction proceeds as follows.

Step 1. A loan is initiated and the following terms of the loan are negotiated:


 * Collateral: it is common for lenders to receive 102% of the value of loaned U.S. stocks and 105% of the value of non-U.S stocks.
 * Rebates: because borrowers forgo the income on the cash collateral, the lender sometimes rebates a negotiated part of the interest earned on the collateral back to the borrower at the conclusion of the transaction. Rebates are common for loans of highly liquid stocks, and are rare for non-liquid stocks, which may even require a negotiated premium from the borrower.
 * Duration: the term of the loan is determined.
 * Dividends: since distributed dividends accrue to the borrower during the term of the loan, the loan agreement usually requires that the borrower pay back the lender the value of any accrued dividends.

Step 2. The borrower delivers the collateral to the lender (or the agent lender). The lender supplies the securities to the borrower's custodial bank.

Step 3. The cash collateral is reinvested for income.

Step 4. The loan agreement is renewed on a daily basis. The values of both the loaned security and the collateral are marked to market each day so that the 102% or 105% collateral levels are maintained.

Step 5. At the conclusion of the loan, the borrower returns the securities, and the lender returns the collateral, plus any rebates.

Security lending risks
There are two main risks involved in securities lending:
 * 1) The risk that a borrower fails to return the borrowed securities.
 * 2) The risk of losses when investing cash collateral.

Recent history
U.S. mutual funds increased security lending in the decade preceding the 2008 financial crisis. The percentage of active funds using security lending increased from 10.8% in 1996 to 43.3% in 2008. Over the same period, the percentage of index funds using security lending increased from 16.0% to 65.3%. The following table shows the number of funds that permitted security lending, and the number of funds that actually used security lending over the 1996 - 2008 period.

Numerous security lending programs incurred losses during the 2008- 2009 financial crisis. A primary cause of investor losses involved losses in the agent lender cash collateral accounts. These losses spawned lawsuits and settlements

In July 2012 Fidelity announced the establishment of a transparent pricing service that would allow hedge-fund clients of Fidelity's brokerage operations to compare lending rates from various Wall Street firms.

In February 2013 the Laborers Local 265 Pension Fund of Cincinnati and the Pipefitters Local No. 572 Pension Fund of Nashville filed a lawsuit against Blackrock iShares alleging breach of fiduciary duty involving the allocation of security lending income to investors. Blackrock iShares allocates 65% of security lending income to its ETFs and 35% to its affiliate Blackrock lending agent.

Short selling stock
Selling stocks you do not own, with the intention of repurchasing them at a lower price later, is known as selling stock short. The act of buying back the stocks that were sold short is called "covering the short" or "covering the position". A short position can be covered at any time before the stocks are due to be returned.

As the stock owner retains the share rights, the borrower must pass all dividends received to the owner. Voting rights are also retained by the stock owner.

An equity lending market exists to match these short sellers with owners of the stock willing to lend their shares for a fee.

Refer to the figure below. An investor who wants to sell a stock short first finds a party willing to lend the shares. The shares are then sold short and delivered to the borrower, with the lender receiving 102% of the loan (US stocks) in collateral. When the shares are returned to the lender, the collateral is returned to the borrower.

While a stock is on loan, the lender invests the collateral and receives interest on this investment. Generally, the lender returns part of the interest to the borrower in the form of a negotiated rebate rate. Therefore, rather than fees, the primary cost to the borrower is the difference between the current market interest rate and the rebate rate the lender pays the borrower on the collateral.




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The stock owner faces three types of risk when lending stock:
 * Investment risk: Choices that the beneficial owner or their agent make in investing collateral
 * Counterparty risk: The borrower fails to provide additional collateral or fails to return the security
 * Operational risk: Responsibilities of the lender or borrower are not met

The stock borrower faces two types of risk: the risk of a loan recall and the risk of a decrease in rebate rates.

White papers

 * Securities lending: Still no free lunch Vanguard Institutional, 07/11/2011
 * Securities Lending and Repos: Market Overview and Financial Stability Issues, Financial Stability Board, 27 April 2012.