What's New in Securities Lending

Though it began as way to settle fails, securities lending has become an integral part of the securities industry. Every since the Securities Act of 1934 permitted it, broker/dealers have been able to affect transactions they would otherwise not have been able to.

“Hedge funds depend tremendously on this business,” said Steven E. Cutler, Managing director o f Banc One’s Investors Advisors Security Lending Corporation, Columbus, Ohio, as well as chairman of Robert Morris Associates Investment Committee on Securities Lending.

Broker/dealers like Bear Sterns of New York borrow from bank trust departments like Banc One, where pension funds, mutual funds and other large institutional funds hold their securities. At the end of the chain is a short seller, typically a hedge fund or some other investor who’s selling short, said Michael Minikis, treasurer and co-president of Bear Stearns Securities Corp., New York.

According to Cutler, a loan security has five characteristics: (1) The borrower agrees to provide collateral; (2) The borrower must agree to return identical securities to the lender; (3) The borrower agrees to pay a fee to the lender; (4) The borrower has unrestricted use of the loan securities–he can do whatever he wants with them; (5) The lender retains all the economic benefits associated with the loaned securities. Price movement up and down is still the risk of the lender. Any dividends, interest, or corporate actions that take place while the securities are on loan go to the owner, except the right to vote securities. Also the owner of the securities has the right to sell them. Lenders must keep track of where their securities are, so they can get them back in time for settlement.

The securities most attractive for lending are those in short supply–a small cap portfolio, non-dollar and foreign securities, new issues, etc. These are lent by public retirement funds, insurance companies, corporate pension funds, mutual funds, and bank trust departments to broker/dealers said Minikis.

Broker/dealers borrow securities to cover short sales and to finance transactions. Lenders earn a fee from the transaction, an incremental yield to the fund. But the underlying benefit of securities borrowing is to accommodate short sellers, according to Anthony Schiavo, principle with Morgan Stanley Dean Witter.

A lender can only lend securities on behalf of clients that have authorized it to do so. The client first signs an agreement to let his assets into the program and the lender signs a contract with the broker/dealer for those securities. “The hardest part is getting those agreements in place,” said Minikis. “In the U.S. it’s an efficient and automated process, but in foreign countries it can be difficult.”

When a lender receives the request from a broker/dealer to borrow securities, the order is checked against the lender’s securities available for loan. The lender gives the borrower an immediate confirmation and the order is written up for delivery. Orders are then passed to the cashier for processing. A securities lending representative then locates the security and notifies the borrower that the security is available for borrowing.

Generally, only the borrower’s securities lending representative is authorized to determine from which lender securities should be borrowed, based on knowledge of which firms have certain securities, historical loan and borrow data, and marketing initiatives.

The lender then determines the kind of collateral, the price of the security, and delivery instructions–a number of brokers have multiple DTC accounts or multiple accounts in the Federal Reserve book entry system. The term of the loan must also be negotiated. The majority of securities loans are done on an overnight basis, so they renew themselves everyday, according the Cutler. While the securities stay out, the broker/dealer and lender can renegotiate the terms. Lastly, a fee must be negotiated. The fee is determined by the type of collateral that has been negotiated. If it’s non-cash collateral–letter of credit or securities–then the broker agrees to pay a negotiated fee that’s a market driven number.

The cash collateral the broker/dealer gives the lender equals the market value of the securities plus 2% for domestic securities and 5% for foreign ones, according to Schiavo.

Cutler said that when the broker/dealer provides cash as collateral, he expects a rate of return on that cash called a rebate rate, determined by supply and demand. If there’s a large supply and a low demand, a higher rebate rate prevails and vice versa. The lender takes that cash and invests it in a money market instrument that provides an investment rate of return, which the lender invests in a short-term investment–commercial paper, repurchase agreements, etc. The gross fee for the lending of the securities is the difference between the investment rate of return (that which the lender invested in and earned) and the rebate rate (how much the lender has to pay back to the broker.) This is split on a percentage basis between the client and the lending agent.

After all points are agreed upon, the lender must keep track of everything it’s done. One way is by “marking to the market,” or continually pricing the securities daily and demanding additional collateral if the price of the loan securities goes up and vice versa. During this entire process, the securities move by book entry.

There are risks, however–broker risk, cash-collateral risk, and operations risk said Cutler. A lender must deal with a broker who will be there tomorrow so it can get its securities back. The lender must also make sure that the investment it makes with the cash it receives as collateral will mature, so it doesn’t lose the money. Finally, the lender must track, price and balance its borrowed securities to prevent operational hazards.