Securities Lending

Securities Lending is the act of large financial institutions with long positions in securities ‘lending’ out those positions to prime brokers to further lend to hedge funds and investors that want to short the particular security.  The process creates incremental revenues for many of these large financial institutions; most commonly mutual funds, pension funds, insurance companies and offshore investment funds that have massive amounts of capital within their portfolios.

The size of the market is estimated to be a staggering $717 billion for US equities.  One of the crucial points to note is the lack of a widespread functional exchange in which to transact security lending agreements.  Security lending transactions still occur almost exclusively over the phone.  It is one of the few transactions in today’s market that agreements are only reached by a prime broker picking up the phone, calling an asset manager and looking to set the terms of agreement.

Equity positions are lent out to brokers, hedge funds and proprietary trading desks with 102% – 105% collateral provided to the lending firm, giving these firms even more cash to invest in other securities; most commonly short-term money market investment vehicles.  However, during the brunt of the crisis news surfaced that some institutions were in fact putting the capital in much higher risk securities such as mortgage-backed investments.  This remains a potential risk to investors who have bought shares of mutual funds or ETFs (Exchange Traded Funds).  If the ‘lent out’ capital is reinvested in risky assets and losses on those positions occur, this loss of investment on the collateralized securities carries through to the total performance of the fund.

What determines the fees and revenue generated by the lending firm?  It is a combination of factors including:  length of the loan, size of the loan, availability of the security in the open market, and stock-specific measures such as dividend amount on the underlying security.  Estimates on how lucrative the business is pegs lenders such as mutual funds and pension funds making anywhere from 1 to 2 percent per annum on the loaning out of positions, while prime brokers are making between 3.5% and 7.25% over the same period. 

Each transaction depends on the stock but can bring as little as 0.01% per transaction or as much as 0.40%.  Securities in extremely high demand can fetch all the way into the double digit percentage points, as seen by Citigroup in 2009 when hedge funds anted up to pay as much as 13% for getting a lot of the shares to sell short.

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