7 Things You Didn’t Know About Securities Lending
Securities lending is one of the best keep secrets in financial services, largely confined to big financial institutions who are running the process in the same way as they were decades ago.
However, every owner of stocks, bonds and ETFs has the right to lend these – meaning that in this unrealised market there are around $40tn of assets collecting dust. Below, Boaz Yaari, CEO and Founder of Sharegain, explains everything you need to know about securities lending.
In short, securities lending is due a revamp so that it can be fit for purpose in a post economic crash, 21st-century financial world. This would result in a more efficient and regulation compliant process for large banks and assets managers; huge cash potential for private investors and wealth managers; and greater liquidity and long-term trust in capital markets.
Securities lending is a long-established practice in capital markets that has until now been largely confined to big financial institutions, even though every owner of stocks, bonds and ETFs has the right to lend them. As a consequence, most asset owners know little about this lucrative practice, which has become a global industry with a massive $2tn of assets on loan on a daily basis. Here are some of the intricacies that make this such an exciting space:
Securities lending is a long-established practice in capital markets that has until now been largely confined to big financial institutions, even though every owner of stocks, bonds and ETFs has the right to lend them.
- Securities lending has been going on for over 40 years. The first formal equity lending transactions took place in the City of London in the early 1960s but it really took off as an industry in the early 1980s. The practice has evolved from a back office operation to a common investment practice that enhances returns for big financial institutions.
- Securities lending plays an important economic function in capital markets. It brings greater liquidity and efficiency to the market, ensures the settlement of certain trades, promotes price discovery and facilitates market making. It also plays a critical role in derivatives trading, certain hedging activities and other trading strategies that involve short selling.
- Securities lending is a great source of alpha, and a way to earn from the hidden value of your portfolio. Earnings from lending are dependent on the level of availability of your stocks. The more widely available stocks, known as ‘general collateral’, generally produce lower returns, of up to 0.5% (50 bps). Hot stocks, known as ‘specials’, can command much higher returns varying from 1.0% (100 bps) to over 100% (10,000 bps) annually in more extreme cases.
- Sometimes short-sellers are right! For example, they spotted that there was trouble with construction company Carillion long before anyone else. A year prior to its collapse, Carillion was the FTSE 250 most shorted stock, which should have sounded alarm bells. However, at other times they are wrong. They can misunderstand the present or future business of a company, as we saw with online supermarket Ocado and a share surge in early 2018 which wiped out $382m for short sellers. At the end of the day it’s not the short sellers who dictate the long-term direction of the stock but the performance of the business itself.
- Did you know that fund managers, active or passive, engage in securities lending to help boost a fund’s performance or offset its costs? This has helped keep index fund charges down, which is hugely important in an age where the hunt for alpha has taken more importance – and where fees are under the microscope.
- In general, securities lending has negative beta to market conditions, with all things being equal. When stocks rise in a bull market, demand to borrow securities wains and lending rates are lower, but you do enjoy the appreciation of your assets. On the other hand, in a bear market (when stocks depreciate), demand to borrow stocks increases and so do lending rates. This way you benefit from a new stream of income to mitigate the volatile times.
- Demand for borrowing ETFs is growing exponentially, with the huge swing towards passive investing over the past decade or so, and currently there are over a 100 ETFs returning more than 2.0% (200 bps) to lenders.