Securities lending and borrowing (SLB) is one of the least-talked-about investment strategies, but which is nonetheless a common practice in securities markets. It involves the transfer of securities from a seller (lender) to a buyer (borrower) for an agreed period and at an agreed fee.
The fee is used as collateral to secure the transfer and it usually has a higher value than the borrowed security. Depending on the agreement between the two entities transacting the business, the fee can be cash or its equivalents such as stock or bonds.
Lenders are usually large institutions with bulk shares that they intend to hold over the long term. This, therefore, allows them to periodically lend these shares and profit from the fees paid in the hope that the stock market will move in their favor during the lending period.
Therefore, securities lending is a way of generating “passive” income from the assets instead of holding on to them with no intention of trading. It is comparable to the way banks loan their customers, who have to pay monthly interest in addition to repaying the principal amount. The only difference is that the principal amount, in this case, is returned in large tranches.
Borrowers’ motivation for hiring the stock is to trade with them, with the hope that the stock’s price trajectory will favor them and earn them a profit. Borrowers bear the greatest risk because they can find themselves losing positions soon after hiring the stock.
The risk levels for issuers of the stocks are comparatively lower because of the assurance that they will get back their stock and have collateral that can theoretically cover their positions in case the market becomes unfavorable to them. The downside comes in when stock prices rise by large margins after lending them. This results in the borrowers making more profit than the over-collateralized lenders.
Securities markets depend a lot on lending and borrowing of stock to maintain their liquidity. This is because borrowers are usually short-term traders who will keep the markets vibrant by putting frequent orders, unlike the lenders who hold the assets for the long term.
The controversy surrounding securities lending
When securities are loaned, the buyers get not only the stock but also the voting rights that accompany such stock. If the lender needs to exercise their voting rights on critical company decisions, they cannot do so immediately and instead have to hold on until they get back their shares. This can put them at a great disadvantage and possibly adversely affect company performance during the intervening period.
The second controversy relates to the short-selling of stocks that were otherwise held long. The argument against this practice is that short sellers are in securities markets to make quick kills and profit by aggressively pushing shares in a manner that is most likely to favor them. In the end, it has been argued, share prices come under undue pressure and end up in positions that may not be the true reflection of the company’s performance.
Sometimes short-sellers are right. They can spot trouble with a company long before anyone else. Some of the companies that have collapsed were the most shorted before their collapse.
Benefits to securities lending
Despite all the criticisms labeled against them, short-sellers are often the first ones to detect underlying problems in companies even before the rest of the market does. In many instances, companies have folded in the last few weeks following widespread short-selling.
Securities lending also ensures that market indices are tracked more closely and with greater scrutiny. This helps investors to decide their preferred companies based on the demand for their shares and borrowing of their securities.
Securities lending is also an effective way of improving the balance sheets of the issuing companies. While the profit margins realized from the lending may not be big, the monies generated can be used to grow the companies. Besides, the requirement for collateral minimizes the probability of incurring losses.
The downside to securities lending
While lenders are largely insulated against losses, sometimes stock prices appreciate while under the custody of the borrowers. As much as these assets are usually over-collateralized, it is not uncommon for them to make gains that far outweigh the profit generated by the lenders.
In such a case, the lender will find themselves staring at a loss because they would be forced to buy back their shares at a higher price. For example, if the lender issued 1,000 shares at $10 per share and the stock rose to $40 per share, then the lender would technically be set back $30,000 before subtracting the profits made from the fees. If they are unable to raise that amount, then they can lose their assets.
In equally bad circumstances for lenders, they may at times opt to re-invest the money they received as collateral/fees in other securities hoping that the security will appreciate. In case the bought securities’ prices slump, then the lender will end up with a loss because they won’t be able to raise enough cash to refund the borrower on the expiry of the contract period. This was a common occurrence in the period leading to the 2007/2008 economic recession, which led to the collapse of Lehman Brothers.
Bottom line
Securities lending and borrowing is a great strategy to make profits with minimal risks. However, investors should understand the downsides involved and ensure that they don’t take up positions that may expose them to losses.
