Securities lending involves transferring ownership of assets from one party to another to generate profit. Institutional investors such as pension funds and hedge funds are typical borrowers, and collateral is used to offset risk. Lenders retain ownership rights but lose voting benefits. Risks include counterparty risk, but lenders can mitigate this through credit checks and daily assessments.
Securities lending is the transfer of ownership of stocks, bonds, or other assets from one party to another. A lender may engage in this activity to generate profit from a portfolio. Lenders retain ownership rights, but lose voting benefits that might otherwise be granted to shareholders if the loaned assets are shares. The borrower is legally responsible for returning securities that are similar in design and value to the loaned assets after the loan term to the lender. Collateral, including cash or bonds, valued at at least the loan amount, is generally used to offset some of the risk.
There are several types of investors who participate in securities lending, although the practice is generally among institutional investors who oversee large sums of other people’s money more than it involves individual investors. Mutual fund managers, public and private pension funds, as well as endowments and foundations are active in the practice of securities lending. Typical borrowers may include prime brokers, which are entities that lend money and securities to hedge funds; trading desks at large banks that trade in the bank’s money; and hedge funds. Securities lending transactions are facilitated by a third party, such as a stockbroker or custodian bank.
Mutual fund managers and other investment advisers oversee baskets of securities for investors and are paid to preserve and grow wealth over time. A manager may choose to engage in stock lending as a way to generate short-term profit. Other reasons could be to increase the overall returns of a portfolio or to offset other investment costs.
Some hedge fund managers are in the business of trading stocks they do not own in an attempt to increase returns on a trade. A manager may borrow securities from a primary broker to cover a position in a trade. There are also some investment strategies that rely more on stock lending, including pair trading. In this strategy, for every bet a manager makes that a stock will go up, he bets another bet that a similar security will go down in price, which is a way of hedging investments. Some of these trades may be done with the fund manager’s own money, but no doubt some of the securities will be borrowed due to the many trades involved.
Investing comes with no guarantees, and stock lending is no different. The risks include the possibility that a borrower defaults on a loan and does not deliver the promised values after the end of the contract. This is known as counterparty risk, and a lender may attempt to mitigate this exposure by conducting extensive credit checks and conducting daily assessments of the value of the securities lent.
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