Securities lending

From Bogleheads
Jump to navigation Jump to search

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. [1] 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. [2] 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.[1]

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.[1]

Who Lends and Who Borrows[1]
Securities Lending.png

Lender motivations for lending securities can include:

  • Offsetting the expenses of managing and administering an investment portfolio; [note 1]
  • Maximizing overall portfolio performance;
  • Foreign investors employing dividend arbitrage to reduce effective tax rates on dividend income.[2]

Borrower motivations for borrowing securities can include:

  • Covering short positions;
  • Hedging investment positions;
  • Arbitrage;
  • Gaining voting rights. [2]

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. [3]. The agent lender may be an independent entity, or an affiliate of the lender. [note 2]

The lender may pass along all, or a portion of net security lending income to the fund portfolio. [note 3]

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. [2]

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%. [4] 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. [note 4]

Table. U.S. mutual fund security lending (1996 -2008) [5]


(View Google Spreadsheet in browser, then File --> Download as to download the file.)

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. [6] These losses spawned lawsuits and settlements [note 5]

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. [7]

In February 2013 the Laborers Local 265 Pension Fund of Cincinnati and the Pipefitters Local No. 572 Pension Fund of Nashville filed a lawsuit [8] against Blackrock iShares alleging breach of fiduciary duty involving the allocation of security lending income to investors. Blackrock iShares allocated 65% of security lending income to its ETFs and 35% to its affiliate Blackrock lending agent. [9] The lawsuit was dismissed in an August 2013 district court decision. [10]

Notes

  1. The table below provides an example of expense offsets from the 2014 fiscal year results of Vanguard index funds. Vanguard runs its own security lending program, bypassing agent lenders. The firm elects to deal directly with borrowers, loans out illiquid stocks to reap premiums, and runs its own collateral investment program using its Market Liquidity Fund. The firm currently does not lend out fixed income securities (see Vanguard fixed income funds discontinue securities lending). Vanguard allocates 100% of security lending income to its funds.
    Vanguard security lending

    google drive spreadsheet

    Additional years:

  2. In a 2012 research paper, Affiliated Agents, Boards of Directors, and Mutual Fund Securities Lending Returns authors Adams/Mansi/and Nishikawa find that index funds executing security lending through affiliated agent lenders provide,on average, lower security lending returns to fund investors than do funds that administer their own lending programs. They also find that excess director compensation is negatively associated with securities lending returns, while board independence and director fund ownership are positively associated with lending returns.
  3. Dimensional Fund Advisors, T. Rowe Price, and Vanguard pass along 100% of security lending income to the mutual fund/ETF investor. State Street passes along 85% of security lending income for eligible portfolios. Note that funds organized as grantor trusts (e.g. the SPDR S&P 500 and SPDR S&P Mid Cap 400 ETF) are forbidden from loaning securities. Blackrock iShares pass along 70% to 75% of security lending income to its iShares ETF investors.
  4. Evans/Ferriera/Prado found that over the 1996 - 2008 the average active fund using security lending provided, on average, some 0.5% to 1.00% lower returns than active funds that did not use security lending.
  5. See the following links for accounts of litigation regarding security lending:

References

  1. 1.0 1.1 1.2 1.3 Securities Lending: An Introductory Guide
  2. 2.0 2.1 2.2 2.3 Securities lending: Still no free lunch Vanguard Institutional, 07/11/2011
  3. Securities Lending by U.S. Open-End and Closed-End Investment Companies, SEC
  4. Evans, Richard B., Ferreira, Miguel A. and Prado, Melissa Porras, Equity Lending, Investment Restrictions, and Fund Performance (January 14, 2013). Available at SSRN: http://ssrn.com/abstract=2101604 or http://dx.doi.org/10.2139/ssrn.2101604
  5. Evans, Richard B., Ferreira, Miguel A. and Prado, Melissa Porras, Equity Lending, Investment Restrictions, and Fund Performance (January 14, 2013). Available at SSRN: http://ssrn.com/abstract=2101604 or http://dx.doi.org/10.2139/ssrn.2101604
  6. Now that the securities lending business has blown up, Wall Street wants to stick you with the bill., Forbes Magazine dated June 22, 2009
  7. Fidelity Targets Securities Lending , WSJ July 26, 2012
  8. Legal Complaint Tennessee pension plans vs. Blackrock
  9. Lawsuit against iShares puts spotlight on securities lending by ETFs, Investment News. Retrieved 7 February 2013.
  10. BlackRock Wins Dismissal of Funds’ Securities Lending Lawsuit, Bloomberg News, August 29, 2013, viewed July 18, 2014.

External links

Bibliography

White papers
Academic papers