Securities Lending: Definition, Process & Benefits

Securities lending is the act of lending or loaning a financial security, a stock, bond, or derivative, to a firm or an investor. It involves the borrower to provide collateral for the security that they are borrowing. The collateralCollateralCollateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments. can be in the form of either cash, bonds, shares or letter of credit (LOC).

A securities lending agreement governs the terms of a security lending loan. The agreement includes the type of collateral – cash, securities or LOC – of value equal to or greater than 100% of the loaned security. The borrower of the security will pay a lending fee, which is typically paid monthly to the lender. Also, the borrower is contractually obligated to return the loaned security either on a pre-determined date or on-demand by the lender.

Common Applications

One of the most common applications for securities lending is short sellingShort SellingShort selling is the practice of selling borrowed securities – such as stocks – hoping to be able to make a profit by buying them back at a. A short sell is when a party sells a security and then repurchases it at a date in the future. It is a trade that takes the position that the underlying security value will decrease in the future.

However, to short sell, a party must be able to sell the security first. It is commonly achieved through securities lending. A party would borrow a security, provide collateral, sell the security, then repurchase it in the future (hopefully at a lower price) and return the security to the lender. The collateral that the borrower supplies is typically equal to the security.

Furthermore, if the underlying security pays a dividend or accrues interest during the period the borrower holds the security, the borrower must pay the dividends or accrued interestAccrued InterestAccrued interest refers to interest generated on an outstanding debt during a period of time, but the payment has not yet been made or to the lender. Securities lending is also common among funds. Funds will lend a security to earn a lending fee, which is paid by the borrower.

Securities Lending Benefits

From the lender’s point of view, the benefits of securities lending include the ability to earn additional income through the fee charged to the borrower to borrow the security. It could also be viewed as a form of diversification.

From the borrower’s point of view, it allows them to take positions like short selling. It also gives investors more options to take different views on the market. For the market as a whole, as mentioned above, it helps to increase liquidity. Increasing liquidity in the market tends to also tighten spreads, which is beneficial to all market participants as the gap between the bid and the ask decreases.

Securities Lending Risks

All investment strategies involve risk, including securities lending. As a lender, the main risk is that the value of the collateral decreases below the cost of the security that was lent out. Another risk to the lender could be that the borrower becomes insolvent and is unable to return the borrowed security.

Additionally, a timing risk could occur for the lender if the lender gives the borrower the security before receiving the collateral. As a borrower, the main risk is that the value of the security increases after a short position is taken. When the borrower takes a short position and the value of a security increases, the borrower essentially has sold low and bought high, losing money.

Securities Lending and Market Liquidity

Empirical evidence supports that securities lending helps to provide liquidity in over-the-counter markets. It helps facilitate various trades that allow investors or institutions to hedge, take a bespoke position, or in arbitrage situations.

Securities lending is a common practice in insurance companies. Insurers may take long-term investments to match with insurance liabilities. Thus, the securities are not actively traded. It gives rise to the opportunity for insurance companies to lend the securities and earn a fee to boost returns.

Furthermore, if cash collateral is given to a lender, it is typically reinvested. The reinvestment increases trading in the markets, which tends to lead to an increase in market liquidity and the tightening of spreads.

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• Asset-Based LendingAsset-based LendingAsset-based lending refers to a loan that is secured by an asset. In other words, the loan is collateralized with an asset (or assets) of the borrower.
• LiquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount.
• Quality of CollateralQuality of CollateralQuality of collateral is related to the overall condition of a certain asset that a company or an individual wants to put as collateral when borrowing funds
• Underlying SecurityUnderlying SecurityUnderlying security is a term in investing that denotes the negotiable financial instrument upon which a financial derivative, such as an