Many are familiar with asset trading but securities lending may be an unfamiliar topic. We’ll provide a basic overview of how securities lending works and discuss some of the key benefits that come with it. We’ll also touch on some risks associated with trading and securities lending and explain how traders can minimise these risks. So, if you’re curious about securities lending and want to learn more, read on.
What is securities lending?
In its simplest form, securities lending is loaning out your securities to another party in exchange for cash or other securities. The loan is typically collateralised, which means that the borrower must provide some form of security to the lender in case they default on the loan.
There are two main types of securities lending
Over-the-counter (OTC) securities lending- is when two parties agree to a loan without going through a third party. OTC contracts are often used to lend out illiquid or hard-to-borrow securities.
Exchange-traded securities lending- This is when securities are loaned out through an exchange. The most common type of exchange-traded securities lending is short selling.
Why do people lend securities?
There are two main reasons why people lend securities
To generate income- When you loan out your securities, you typically receive a fee. This fee can boost your income, especially if you’re holding an extensive portfolio of securities.
To borrow securities- There are times when you might want to borrow securities from somebody else. For example, you might want to short sell a security or engage in other trading strategies.
How does it work?
In most cases, securities lending is done through a broker-dealer. The broker-dealer will act as the middleman between the two parties and will typically take a transaction cut.
Here’s how it might work:
- You have a hundred shares of XYZ stock that you want to loan out.
- You contact your broker-dealer and tell them that you want to lend out your XYZ shares.
- The broker-dealer finds a party who is willing to borrow your XYZ shares.
- The borrower pays a fee to the broker-dealer for borrowing your XYZ shares.
- The broker-dealer passes on the fee to you, minus their commission.
- You continue to own your XYZ shares and can trade them anytime.
- At the end of the loan period, the borrower must return your XYZ shares to you.
What are the benefits?
There are vital benefits that come with securities lending
It’s a great way to generate income- As we mentioned, one of the main reasons people lend securities is to generate income. If you have an extensive portfolio of securities, you can potentially earn a decent amount of money from lending them out.
It’s relatively low risk- Securities lending is generally considered a low-risk activity. It is because the loans are typically collateralised, which means there’s a lower chance of default. Additionally, most brokers will require the borrower to have a strong credit rating before they can borrow securities.
What are the risks?
While securities lending is generally low risk, there are a few potential risks that you should be aware of:
Default risk- This is the risk that the borrower will default on the loan. While this risk is typically low, it’s still important to be aware of it. One way to minimise default risk is to only lend your securities to borrowers with solid credit ratings.
Counterparty risk- This is the risk that the other party in the transaction will not fulfil their obligations. For example, if you’re lending your securities through a broker-dealer, there’s a risk that the broker-dealer will go bankrupt and be unable to return your securities.
Who participates in the market?
There are three main types of participants in the securities lending market.
Lenders- are typically institutional investors, such as hedge funds, pension funds, and insurance companies.
Borrowers- are typically hedge funds, broker-dealers, and other financial institutions.
Intermediaries- are typically broker-dealers or other financial institutions that act as the middleman between lenders and borrowers.
What are the largest securities lending markets?
The US and Europe are home to the world’s two largest securities lending markets. The Securities Lending Association (SLA) is the primary trade association for securities lenders in the US. In Europe, there is no equivalent trade association. However, many exchanges, such as the London Stock Exchange, offer securities lending services.
To summarise, securities lending is loaning out your securities to another party in exchange for cash or other securities. It’s a relatively low-risk way to generate income, but there is a slight chance that the borrower will default on the loan. If you’re considering lending your securities, understand the risks involved before doing so.