Securities Lending In Depth

Securities lending is an investment strategy employed to raise additional income from existing assets, thus increasing overall portfolio performance. Securities lending is a combination of two processes: a borrowing transaction and an investment transaction. In the borrowing transaction, securities are "lent" by a beneficial owner in return for cash collateral. The beneficial owner is the party who is entitled to the actual benefits of ownership, for example, voting rights, accrued interest, and market value changes. In the investment transaction, cash collateral received is reinvested in an income-earning asset. To fully understand this market, one must understand where the demand for these securities comes from, as well as who the major beneficial owners are.

Funding Sources

Major broker-dealer firms view securities lending from two vantage points: Funding-the-firm and covering short positions. Dealers have huge inventories of fixed-income securities and need to fund them on a daily basis. This is much like an auto dealer who "floors" his inventory. The cheapest method of financing is to borrow money in the overnight Repurchase Agreement (Repo) market. The lowest Repo rates are those secured by U.S. Government and agency collateral. Most of the securities that a dealer carries in his inventory are not Government backed, so there is an incentive for the largest dealers to "borrow" U.S. Government and agency backed bonds from those who have them and use them to raise overnight money at the cheapest rates. This is where credit unions come into play, since by regulation federal credit unions must invest primarily in debt issues of the U.S. Government and its various agencies.

To understand the whole transaction, it is important to realize that most of the cash that is raised by dealers comes from large governmental and pension fund entities who are required as fiduciaries to accept only the highest quality collateral to secure their cash, even overnight. Dealers borrow the high-grade collateral they need from the beneficial owner via a reverse repurchase transaction. The easiest way to complete the transaction is for the beneficial owner to then invest in a collateralized Repo with the same dealer who borrowed the securities, taking collateral from that dealer's inventory that meets the safety and soundness standards of the beneficial owner's investment regulations. The dealer has now accomplished the goal of funding the firm.

The beneficial owner will be paid a fee for the use of his securities as collateral. Technically, this fee is the difference between the cost of loaning the securities, and the rate earned on the cash collateral reinvestment. In recent years, this spread has been between 5 and 10 basis points on collateral that is permissible for federal credit unions.

The other main reason that dealers need to borrow securities is due to the common practice of shorting the market. Often, dealers are asked by customers to offer securities which they do not own, most often large and highly liquid U.S. Treasury and agency issues. Alternatively, they will simply make a bet on the market direction by selling these issues short. To fulfill their legal obligation on these trades, they must cover these short positions by borrowing the securities. These securities are often in high demand, and are called "specials," because of the special rate they command in the securities lending market. Often the rate dealers charge to borrow these securities is well below the prevailing overnight Repo rate, making these very lucrative securities to loan for the short term.

Beneficial Owners

The major beneficial owners who participate in the securities lending market by lending their assets include plan-sponsored programs from all 50 states, most major pension funds, many families of mutual funds, bank portfolios, hedge funds, and the largest credit unions, both natural-person and corporate. The major incentive is the stable fee income generated by otherwise idle assets. As the industry has matured and more lenders and borrowers are participating in this activity, operational concerns and liquidity risks have become more manageable.