Securities Lending

Securities lending involves a loan of securities to a broker-dealer, which uses those securities to facilitate a delivery of a short sale. the loan is temporary with an obligation to return that loan at a future (undetermined) date.

A short seller will contact one or more prime brokers to determine if a company’s shares can be borrowed. If the shares are hard to borrow — signaling that the potential costs of stock loan fees and other factors would make shorting the stock prohibitively expensive — the short seller may decide not to short the stock. If they decide to trade a short position, or increase an established position, they ask the prime broker for an affirmative determination that the stock can be borrowed and confirm its “locate” determination.

Prime brokers can borrow from retail margin accounts; custodians that hold institutional (mutual funds, pension funds and college endowments) portfolios and from their own firm’s proprietary trading accounts. lenders generally earn fees that enhance investment returns.

Prime Broker Borrows Stock

The short seller never locates or borrows a share of stock. it is the prime broker that facilitates delivery of the short sale. the stock loan transactions are maintained on the books of the prime broker. regulation SHO requires that, before effecting a short sale in any equity security, a broker-dealer must either have borrowed or arranged to borrow the security or have “reasonable grounds to believe” that the security being shorted can be borrowed so that it can be delivered on the date that delivery is due (the “locate requirement”).(28)

The loan’s terms are governed by a “securities lending agreement,” which, under U.S. law, requires that the borrower provide the lender with collateral. (According to the Risk Management Association, a securities lending trade group, 98 percent of U.S. equity loans are collateralized with cash; the remaining two percent use Treasury securities.(29) Specifically, the borrower enters into an agreement with the lender to:

• Secure the loan with collateral of equal or greater value than the lent securities;
• Pay any user fees; and,
• Remit to the lender any dividends, coupon interest, or other distributions that occur during the time that the securities are on loan. (These dividends are referred to as a “manufactured dividend.”)

The borrower must return the shares to the lender upon demand or when the short sale is covered (when the shares are bought by the short seller).

When a security is on loan, the lender retains all the benefits of ownership, including rights to dividends, interest payments, and corporate actions (excluding proxy voting). the lender retains the financial consequences of loaned securities.

It is very expensive to establish and then maintain a short position for any period of time. The prime broker must post and continuously maintain collateral (usually in cash or high-quality government bonds) which, in turn, is charged to the short seller. In addition, the lender must be paid for the use of its shares. a premium may be charged for hard-to-borrow securities. The prime broker will charge the short seller and send most of the premium to the lender. That premium may be substantial — 20 percent or more. Global short selling procedures may change from region to region.

Risks Include Default

Securities lending has risks. A prime broker could default or fail to deliver its borrowed securities as a result of a recall (counterparty risk). Adverse credit and market conditions could diminish the return on the collateral (collateral risk). Collateral is a security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. Price volatility, market liquidity, and exchange rate fluctuations may change the value of the lending terms for the lender and/or the borrower. given that securities lending involves several moving parts, there are operational risks as the transaction moves through clearing and settlement.(30)

The transaction, though, is designed to minimize risks for the lender by being both over-collateralized (meaning the amount of capital committed to repay the loan exceeds the value of the borrowed securities) and governed by industry-standard legal agreements.

Short positions often are not short-term. The short seller locks into the short position and waits — often for months — for the stock’s price to decline. During this wait, the short seller is carrying the costs of borrowing, as well as the risk of upward price movement, additional collateral deposit requirements, and the risk that the borrowed shares will be suddenly recalled by the lender. If the borrowed shares are recalled, the prime broker must automatically either arrange to re-borrow the shares from another lender or buy shares to close out the short position. Additionally, if available shares cannot be located for delivery, the short seller may be buy-in. Hence, shorting is often a long-term position that is costly and risky to maintain.

When the short seller wants to close the position, they will place a “buy” with a broker, who will deliver the shares to the prime broker for return to the lender. The short seller’s profit or loss will be determined by whether it was correct that the stock’s price would fall and by the amount of interest and other expenses that were incurred in borrowing the securities.

On occasion, an anticipated stock lending source fails to provide the shares that the prime broker, who located shares on behalf of its customer (the short seller), believed in good faith were available for borrowing. The short seller will have no knowledge that delivery of the shares failed as a result. in these circumstances, the prime broker goes to work and generally locates shares to borrow from another source. If the prime broker cannot locate a substitute source of shares, the trade is subject to regulatory closeout.

Short sales, like other securities transactions, are cleared through the national securities clearing corporation (NSCC), a subsidiary of the Depository Trust Clearing Corporation (DTCC), which conducts post-transaction clearance, settlement, and custody operations for securities trades. DTCC also has a Stock Borrow Program, which may come into play after a trade is made and as a backup method to supply shares that may have otherwise gone undelivered. Approved by the SEC, this program has been in operation for more than 20 years.

According to the Risk Management Association, during the second quarter of 2008, on average, $12.6 trillion in bonds and equities were out on loan globally. By comparison, total assets under management for equity and bond funds worldwide was $24.8 trillion at the end of the first quarter 2008. Large institutional investors have on average lent 10 percent of their share portfolios, with peaks of 25 percent to 50 percent being recorded in some cases, Data Explorers’ analysis shows.(31)

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