Domen Zavrl has PhDs in applied macroeconomics and system dynamics, having studied in Linz and Vienna, Austria. He also completed Tuck Executive Education at Dartmouth University, as well as taking cryptography courses at Stanford. This article will look at securities lending, exploring the practice’s history and its important economic function in capital markets.
The first formal equity lending transactions occurred in the City of London in the early 1960s, although it was not until the 1980s that the industry really took off. Having evolved from a back office operation to a routine investment practice, securities lending is a common exercise that enhances returns for large financial institutions.
Securities lending brings greater efficiency and liquidity to the market, helping to facilitate the settlement of certain trades, facilitating market making and promoting price discovery. Securities lending also plays a vital role in certain hedging activities, derivatives trading and other strategies that centre around short selling.
The practice enables investors to earn from the hidden value of their portfolio, with earnings from lending dependent on the availability of their stocks. Known as ‘general collateral’, the more available stocks generally produce lower returns of up to 0.5%. On the other hand, hot stocks, which are known as ‘specials’, typically command much higher yields, varying from 1% to over 100% annually in extreme cases.
Sometimes short sellers are right. A prime example occurred during the collapse of the construction company Carillion, when short sellers spotted trouble long before anyone else. A year prior to its demise, Carillion was the most shorted stock in the FTSE 250, which should have sounded alarm bells.
Equally, short sellers sometimes get it wrong, as in the case of the online supermarket, Ocado. In this instance, a share surge in early 2018 wiped out $382 million for short sellers. It is important to appreciate that it is not the short sellers that dictate the long-term direction of stock, but rather the performance of the business itself.
Many fund managers, both passive and active, engage in securities lending to boost the performance of funds or offset their cost. This has helped to keep index fund charges low, which is hugely important in an era where the hunt of alpha has become an even greater priority, and during a period when fees are increasingly being scrutinised.
The aim of securities lending is to help financial markets to function smoothly. The Eurosystem is currently purchasing large quantities of securities of banks to mitigate the risk of inflation being too low for too long. Large-scale securities purchases by central banks are predicted to reduce the availability of securities on the market. Lending securities back to the market means that they can continue to be used by others for their transactions.
There are several reasons investors may opt to borrow a security rather than simply buying it. Sometimes a security is only required on a temporary basis, be it for a few days or a few weeks. In this scenario, it is often quicker, cheaper and less risky to borrow the security rather than purchasing it outright.
Typically, securities are transferred within two business days of a sale being agreed. Sometimes it is very important for the buyer to receive the securities by a set date. If they are going to arrive late for any reason, borrowing a security on short notice offers a means of accessing the missing securities in time.
Securities lending is a longstanding practice in capital markets that has traditionally been confined to large financial institutions. Although all owners of stocks, ETFs and bonds have the right to lend them, most asset owners know little securities lending, a lucrative practice that has become a global industry, with circa $2 trillion of assets on loan on a daily basis.
