.Securities lending allows investors to improve portfolio yield by lending out their securities to short sellers, normally long/short equity hedge funds looking to profit on downward market moves. In return for accepting the locking up of their funds during the trade, as well as the small but real risk of counterparty failure, investors receive a premium that they can then split with their bank or broker as part of a securities lending account agreement. Though not suitable for all investors, for those who want greater yield on existing long-term holdings, and don’t mind exposing themselves to the small but potentially major risk of fund failure, securities lending is a powerful tool for maximizing yield on your portfolio.
Securities lending accounts
Short selling is a common strategy used by hedge funds that focus on rapid trading. It involves borrowing a security, such as a stock, and selling it with the expectation that the price will fall. The hedge fund can then buy back the security at a lower price, return it to the lender, and pocket the difference as profit. Securities lending services facilitate this process by providing the securities that hedge funds need to borrow in order to make short sales. These services are typically offered by large financial institutions, such as banks and brokerages, that hold large portfolios of securities in their own account.
More recently, some banks and brokerages began to offer clients with long-term equity holdings the option to loan out their shares and then split the premiums with the bank. Though it is not suitable for all investors and involves taking on a little extra risk (and the inconvenience of not being able to sell loaned securities), the method can be an effective one for improving yield on equity holdings.
When a hedge fund wants to borrow a security to make a short sale, it will typically contact a securities lending service (normally a bank) and enter into a lending agreement. This can will vary according to the terms but always involve the same basic principles. Once the agreement is signed, the bank will lend the hedge fund the desired security in exchange for collateral. This takes the form of cash or other securities. The hedge fund will then sell the borrowed security. If the price falls as expected, buy it back at a lower price and return it to the lending service. The profit made in the short sale is the difference between the sale and lending prices. However, minus the premium (or lending fees).
The use of securities lending services allows hedge funds to make short sales without having to actually own the securities they are selling. This can be an effective way for these funds to profit from market movements, particularly in volatile or declining markets. At the same time, securities lenders can also earn revenue by charging fees, which are then split with the owner of the security. Saxo Bank Group is one example of a bank or broker offering securities lending services to clients, and more and more banks are offering these services as standard.
The risks involved
All financial premiums are essentially rewards for taking on a risk. In this case, there are two: one which will affect all securities lenders. The second is rare but serious. The first one involves the inconvenience of not being able to sell securities when they are loaned out. Normally short sales are short-term transactions, and a securities lending contract will often have a time limit. But even so, whatever happens to the markets during that period you will be unable to sell. This of course can be frustrating if you see a market top during the loan. However, in general, securities lending accounts should be only restricted to long-term holdings.
It is worth stressing the following scenario is unusual, but it can happen and would put the securities lender in a problematic scenario. Fund failure could result in serious losses for securities investors, who would have a claim to see their assets returned. In a sudden or dramatic failure might not be reimbursed.
If a long/short equity fund engages in short selling, it is taking on additional risk. This is because the value of its short positions can potentially increase indefinitely. Whereas the long positions have a maximum loss of 100% (the total value of the underlying stocks). Suppose the market moves against the fund and the value of its short positions increases significantly. The fund can suffer significant losses, losses which may be magnified by leverage.
When a long/short equity fund fails, the securities it has borrowed from its lenders will need to be returned. If the fund does not have the assets to cover its obligations, the securities lenders may not be able to recover their securities or the fees they are owed, which can lead to losses for the securities lenders. In some cases, the failure of a long/short equity fund can also have broader market implications. Such as reduced liquidity and increased volatility, further damaging overall portfolio returns.
Securities lending is a good way of maximizing returns on long-term assets. However, it is important that investors meet several criteria before signing up for a securities lending account. Firstly, it is important that the assets being lent are for long-term investment only. As the stocks will be impossible to sell when they are being loaned out. Second, investors should be aware that they are splitting premiums with their bank or broker. The broker stands to lose less from an eventual default. An imbalance that should be reflected in the fee division is included in the loan agreement. Finally, investors need to know that they are being paid for taking on risks. That said, it is important not to overstate the risk involved. Fund failures are rare, and even when they do happen, investors are normally at least partially reimbursed.
To learn more about trading and investing, check out The Difference Between Investing and Trading in the Share Market.