Securities lending explained

Market participants 

Borrower

A securities lending borrower is an investor or firm which is borrowing a security.
The most common borrowers of securities are broker-dealers, hedge funds and portfolio managers.

There are many reasons why a borrower would want to borrow a security. These include:

Market making – Some borrowers have agreements to “make markets” in certain securities. This means they are required to be ready to buy and sell these securities for their clients (and on behalf of the company themselves) at any time, so maintaining market liquidity. Consequently, they are required to hold pools of assets that they do not always own – often they need to borrow them. This is how securities lending began in the 1960s.

Short selling (Directional investing)Is the process of selling a security which you do not own.

FinancingTo raise short-term capital (cash) and finance other activities, some institutions borrow securities to sell them or lend them to re-invest the associated cash collateral.

Balance sheet trades – many regulators require banks and other institutions to adhere to liquidity ratios.  Liquidity ratios measure a banks ability to pay debt obligations and their margin of safety should default occur. In order to pass stress tests, some institutions borrow securities to ‘boost’ their balance sheets.

Arbitrage Is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalise upon the imbalance, the profit being the difference between the market prices.

Timely settlement (fails mitigation)– Conventionally, securities are transferred to a buyer two business days after a sale is agreed. If the securities are going to arrive late for any reason, borrowing can be a way to ensure timely delivery.

Hedging – A hedge is an investment to reduce the risk of adverse price movements in an asset (i.e. opposite to your position). Normally, a hedge consists of taking an offsetting position, e.g. going short in one security and long in a related security. Hedging techniques are also widely utilised by banks and brokers in the creation of derivative transactions, in order to offset any exposure created by the creation of the derivative contract, by purchasing or selling the security against which the contract has been created.

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