Securities lending arrangements arise when a holder of securities agrees to provide them to a borrowe...
Borrowers require securities because of the margin, derivative and settlement requirements of the securities markets, while lenders seek an additional return by way of fees paid by a borrower.
Securities lending first appeared in the UK during the 1960s and later came to prominence in other markets including the US, Germany and Japan. It has expanded rapidly in recent years and is now a front office 24-hour global activity. Securities lending activities add liquidity and efficiency to the market place, supporting the trading activities and strategies in all major markets.
It was not until the 1970s that securities lending appeared in Australia and it was not until the late 1980s stock market bull run that the volume of securities lending grew. This growth was tempered by the enactment of two pieces of taxation legislation.
In September 1985, the introduction of Capital Gains Tax legislation (CGT) deemed security loans to be effective disposals for CGT purposes. Most taxable lenders therefore discontinued their activities.
Domestic institutions are increasingly viewing securities lending as a new way to increase revenues, while more overseas institutions are expanding their lending portfolios to include Australian securities.
Due to the fact that securities lending staff are becoming more experienced and the market more sophisticated, desks have frequently moved into the trading areas or have become distinct departments, reflecting the fact they are a revenue centre in their own right.
Reasons for borrowing
Intermediary brokers: These brokers act between lenders and borrowers. The intermediary takes a spread for their services. Many institutions find it convenient to lend stock to one or two intermediaries that then on-lend to many more counterparties. This saves administration and limits credit risks.
Borrowing for margin requirements: To meet margin requirements, for example at the Exchange Traded Options Market, securities can be borrowed cheaply and lodged as margin, rather than depositing cash.
Borrowing for market making and proprietary: Trading market makers and proprietary traders are by far the largest borrowers of stock in Australia and are responsible for most securities lending transactions in the country.
These traders sell stock for a variety of reasons, most of which are hedging-related. Activities under this category include short selling, equity/share price index arbitrage, equity/derivative arbitrage and equity option hedging.
Stock loans drawn down by market makers and traders are typified as being large in volume and long in duration. For lenders, these loans represent the greatest opportunity to maximise profit.
Borrowing for failed trades: A failed trade may be defined as one where delivery cannot be completed because of insufficient securities available. This is not deliberate policy, but is caused by any number of general administrative problems. Borrowings to cover fails are mostly small and short in duration (one to five days). The borrower keeps the loan open only until they can complete delivery of the underlying trade.
An example of this type of transaction occurs when a broker's client sells stock but fails to deliver the securities to their broker. The broker borrows the stock, settles the trade and places the resultant settlement funds on deposit. They thereby earn interest on this cash and avoid fail fines. They then unwind the loan once the client has delivered their securities.
A lender can earn fees on securities loans in two ways. Where a lender receives cash collateral, they are expected to invest this cash and to earn at least the overnight cash interest rate. From the interest received, the lender deducts their fee and rebates the balance to the borrower.
Alternatively, where non-cash collateral is lodged, a fee rate is used to calculate fees payable. The borrower forwards fees to the lender monthly in arrears. The lender's fee is negotiated with the borrower and depends on loan size, duration and availability.
The risks inherent in lending securities are not always readily apparent but must be recognised as an important consideration when operating a securities lending programme.
Counterparty risk: Many complications can arise when a counterparty defaults on its obligations. A thorough credit assessment should be undertaken to determine their financial status. Reviews should be undertaken regularly. It is important to keep in mind that the fortunes of many potential counterparties can change rapidly.
Other factors to take into account include the quality of the counterparty's management and financial controls.
Collateral adequacy: The margin above market value must cover market fluctuations. Risk can be minimised by continually monitoring collateral levels and making timely margin calls. Current market practice in Australia dictates collateral to be at least 105% of the market value of the loaned securities.
Collateral title risk: A lender should always ensure there is clear title to the collateral they hold. This is especially so with cash. An existing charge over the borrower's assets may give a liquidator the right to recall cash collateral without necessarily returning the underlying stock because of imperfect set-off. To a large extent, these problems are addressed in
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