The history of securities lending and borrowing will tell you that it was an informal event between two or more brokers who didn’t have share certificates to settle their sales due to their clients who didn’t provide them to the broker at the settlement date. In this primitive state, there was no agreement as such, nor any regulation and certainly no collateral posted between parties. That same business today is now worth several billion dollars and is an important role within bank treasuries. The basic premise of securities lending is pretty simple where securities are temporarily transferred from the lender to the borrower, who is obliged to return them at the end of the term of when the lender calls them back on demand. However, the transaction is also subject to the borrower providing adequate and sufficient collateral.
This collateral primarily comes in the form of direct cash. Indeed 80%+ of collateral volume is cash. However, modern day banking now sees debt instruments (usually investment grade only), commercial paper, bank acceptances, high quality equities and preferred equities and letters of credit as well as convertible debt instruments. Once the collateral has been agreed upon, the next parameters completing the transaction are the initial margin (which is the level of margin required at the beginning of the transaction), maintenance margin (which is the minimum level that needs to be maintained throughout all market fluctuations) and concentration limits (the maximum percentage of any issue that falls within acceptable parameters). The lender receives the collateral in a segregated account and will mark to market the collateral at the end of each trading day. This type of transaction represents the bilateral transaction.
With the rise in the importance of securities lending, the conventional bilateral transaction added one more player in its chain – something commonly known now as a tri party collateral agent. In this type of transaction, the third player (the “Agent”) will be the one responsible for marking to market the collateral and distributing the results to the lender and borrower. The Agent is paid through the borrower normally who provides a flat fee for their services. This tri party transaction has given rise to a debate where critics say that lenders who are flexible with collateral requirements generally get higher fees attached to their names. However, proponents of this transaction argue that such lenders are able to attract more borrowers due to their flexibility and thus enhance their revenue base as a direct result of that borrower interest.
This gives rise to the question: Why is securities lending and borrowing growing in importance? Banks have identified three main reasons that drive security lending businesses. The first one is to borrow to cover a short, whether it be covering to avoid a settlement failure, market making to create two-way price liquidity or directional shorting where speculation is involved. This is by far the most common reason as hedge funds and other alternative asset managers who are frequently taking short positions engage in securities borrowing to avoid being short-squeezed or to leverage their positions and magnify their returns. Another reason to pursue this is to make arbitrage profits where they can be used to cover a short or hedge a long position, particularly in the cases of convertible bond arbitrage and relative value arbitrage. Lastly, they are used as temporary transfers of ownership to take advantage of tax laws on capital gains and dividends. In the past, investors have used securities lending and borrowing to benefit from tax treaties that vary between counterparts regarding record dates. The tax component is therefore, a good motivator to pursue this activity and earn incremental income on top of the profits off the security.
All in all, the securities lending and borrowing business has grown sharply over the last decade. With the increased proliferation of hedge funds and other arbitrage-seeking market players, the industry looks poised to add to its growing presence within investment banks as a function that provides liquidity, reducing trading costs and promoting greater price discovery.
