WHAT'S NEW IN SECURITIES LENDING
by Bob Brooke
Though it began as way to settle
fails, securities lending has become an integral part of the securities
industry. Every since the Securities Act of 1934 permitted it,
broker/dealers have been able to affect transactions they would
otherwise not have been able to.
“Hedge funds depend tremendously on this business,” said Steven E.
Cutler, Managing director o f Banc One’s Investors Advisors Security
Lending Corporation, Columbus, Ohio, as well as chairman of Robert
Morris Associates Investment Committee on Securities Lending.
Broker/dealers like Bear Sterns of New York borrow from bank trust
departments like Banc One, where pension funds, mutual funds and other
large institutional funds hold their securities. At the end of the chain
is a short seller, typically a hedge fund or some other investor who’s
selling short, said Michael Minikis, treasurer and co-president of Bear
Stearns Securities Corp., New York.
According to Cutler, a loan security has five characteristics: (1) The
borrower agrees to provide collateral; (2) The borrower must agree to
return identical securities to the lender; (3) The borrower agrees to
pay a fee to the lender; (4) The borrower has unrestricted use of the
loan securities–he can do whatever he wants with them; (5) The lender
retains all the economic benefits associated with the loaned securities.
Price movement up and down is still the risk of the lender. Any
dividends, interest, or corporate actions that take place while the
securities are on loan go to the owner, except the right to vote
securities. Also the owner of the securities has the right to sell them.
Lenders must keep track of where their securities are, so they can get
them back in time for settlement.
The securities most attractive for lending are those in short supply–a
small cap portfolio, non-dollar and foreign securities, new issues, etc.
These are lent by public retirement funds, insurance companies,
corporate pension funds, mutual funds, and bank trust departments to
broker/dealers said Minikis.
Broker/dealers borrow securities to cover short sales and to finance
transactions. Lenders earn a fee from the transaction, an incremental
yield to the fund. But the underlying benefit of securities borrowing is
to accommodate short sellers, according to Anthony Schiavo, principle
with Morgan Stanley Dean Witter.
A lender can only lend securities on behalf of clients that have
authorized it to do so. The client first signs an agreement to let his
assets into the program and the lender signs a contract with the
broker/dealer for those securities. “The hardest part is getting those
agreements in place,” said Minikis. “In the U.S. it’s an efficient and
automated process, but in foreign countries it can be difficult.”
When a lender receives the request from a broker/dealer to borrow
securities, the order is checked against the lender’s securities
available for loan. The lender gives the borrower an immediate
confirmation and the order is written up for delivery. Orders are then
passed to the cashier for processing. A securities lending
representative then locates the security and notifies the borrower that
the security is available for borrowing.
Generally, only the borrower’s securities lending representative is
authorized to determine from which lender securities should be borrowed,
based on knowledge of which firms have certain securities, historical
loan and borrow data, and marketing initiatives.
The lender then determines the kind of collateral, the price of the
security, and delivery instructions–a number of brokers have multiple
DTC accounts or multiple accounts in the Federal Reserve book entry
system. The term of the loan must also be negotiated. The majority of
securities loans are done on an overnight basis, so they renew
themselves everyday, according the Cutler. While the securities stay
out, the broker/dealer and lender can renegotiate the terms. Lastly, a
fee must be negotiated. The fee is determined by the type of collateral
that has been negotiated. If it’s non-cash collateral–letter of credit
or securities–then the broker agrees to pay a negotiated fee that’s a
market driven number.
The cash collateral the broker/dealer gives the lender equals the market
value of the securities plus 2% for domestic securities and 5% for
foreign ones, according to Schiavo.
Cutler said that when the broker/dealer provides cash as collateral, he
expects a rate of return on that cash called a rebate rate, determined
by supply and demand. If there’s a large supply and a low demand, a
higher rebate rate prevails and vice versa. The lender takes that cash
and invests it in a money market instrument that provides an investment
rate of return, which the lender invests in a short-term
investment–commercial paper, repurchase agreements, etc. The gross fee
for the lending of the securities is the difference between the
investment rate of return (that which the
lender invested in and earned) and the rebate rate
(how much the lender has to pay back to the broker.) This is
split on a percentage basis between the client and the lending agent.
After all points are agreed upon, the lender must keep track of
everything it’s done. One way is by “marking to the market,” or
continually pricing the securities daily and demanding additional
collateral if the price of the loan securities goes up and vice versa.
During this entire process, the securities move by book entry.
There are risks, however–broker risk, cash-collateral risk, and
operations risk said Cutler. A lender must deal with a broker who will
be there tomorrow so it can get its securities back. The lender must
also make sure that the investment it makes with the cash it receives as
collateral will mature, so it doesn’t lose the money. Finally, the
lender must track, price and balance its borrowed securities to prevent
This article originally appeared in Operations Management.
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