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Securities lending? Interesting

Peter Siks

Summary:  For many investors, securities lending is an unfamiliar term. And if they are familiar with the term, they often find it a complicated part of (international) securities trading. This article explains the how and why of securities lending and how you, as a private investor, can benefit from it.

Securities lending; what is it?

The term denotes the lending of securities for a fee. The lender also receives collateral in the form of other securities (or cash) that exceeds the value of the lent securities. In practice, the value of this collateral varies between 102% and 105% and is monitored and adjusted daily. The lender retains beneficial ownership during the lending period because the loaned securities will be delivered back to it. However, legal ownership is transferred during the lending period. This means, among other things, that no voting rights can be exercised, and dividends are received by the borrower. However, the borrower compensates the lender in the form of a so-called 'manufactured dividend' that fully compensates the missed dividend. The lender can sell its shares at any time. Behind the scenes, the lent securities must then be recalled so that they can be delivered to the buyer of the securities. It is therefore an agreement that can be terminated on a daily basis.

Who's lending?

Parties with large share portfolios, such as pension funds, insurance companies, brokers, banks, and other investors, are often active on the lending market. But investment funds and ETFs can also be securities lenders. Why do they do this? Because for lending securities, they receive a fee that increases the return on their investment portfolio.

Who is borrowing and why?

There is sometimes a misconception that only hedge funds borrow securities because they have gone short and therefore have to deliver those securities to the buyer. They go short to anticipate lower prices, after which they can buy back the sold securities at a lower level and thus make a profit. This does happen, but it only concerns a small part of the demand for securities to be borrowed. According to research by Dow Jones and Credit Suisse, it is less than 1% of the total demand for securities to borrow. The real picture is therefore more nuanced: 
  1. Firstly, borrowing is done in order to deliver on time. The securities lending market offers a solution when there are high fines and penalties attached to not being able to deliver securities to the buyer on time. It facilitates the settlement of securities transactions.
  2. Professional traders are also (indirectly) active in the lending market, such as market makers in options. Being able to sell shares (which they do not own) may be necessary to make the total position delta of a market maker neutral. By selling shares, they are not anticipating a price drop, but it is purely to hedge the risk of the option position.3. The lending market also offers a solution for other liquidity providers. For a party with an obligation to issue bid and ask prices, it is a comfort to know that if demand is high, they can borrow securities.
  3. Also active in the market are arbitrageurs. An example is traders who use minimal price differences between the same share. An example is the ING share, listed in both New York and Amsterdam. If ING (the ADR) is 2 cents cheaper in America than in Amsterdam, then the pieces are bought in the US and shorted in Amsterdam. But this says nothing about the trader's view of the ING share. He is neutral; what matters to him is the arbitrage opportunity of two cents.
  4. There are also index arbitrageurs. They make money from deviations between the futures price and the underlying shares. If the futures price is relatively low, the futures will be bought and the shares will have to be sold to remain market neutral. In other words, they must be able to borrow shares.

In short, the ability to both buy and sell increases liquidity to the benefit of all market participants. Greater liquidity not only reduces the difference between bid and offer prices, it also supports the most efficient price formation. All participants get the opportunity to convert their vision into action on the market. This can mean buying, selling, or going short. This results in the most optimal price formation. This is nicely expressed by SEC Chairman Cox in a CNBC interview in 2008: "There should be some parity between going long and going short. We need the shorts in our market in order to balance so we don't have bubbles.... "

Ban on securities lending

In the hectic investment year of 2008, it was briefly impossible to go short in shares in America. As a result, Marco Pagano and Alessandro Beber, among others, have conducted scientific research. In their research - Short-selling bans in the crisis: A misguided policy - they came to the following conclusion:
"In contrast to the regulators' hopes, therefore, the overall evidence indicates that short-selling bans have at best left stock prices unaffected, and at worst may have contributed to their decline."
This is underlined by the SEC. The US regulator said, through its chairman Christopher Cox, on 31 December 2008, the following about the ban on short selling: "Knowing what we know now, [we] would not do it again. The costs appear to outweigh the benefits".

Who owns it?

If your shares are lent out, you are still the economic owner (you run the price risk and are entitled to a dividend-replacement payment), but you are not the legal owner (you are not allowed to attend the shareholders’ meeting). However, it is important to realize that you as a lender can sell the shares at any time you wish. Naturally, this also ends the right to compensation for the lending. It is therefore not the case that you, as a lender of the shares, do this for a predetermined period.

What compensation can you expect?

The remuneration received by the lender of securities depends on supply and demand. You can imagine that the fee on blue chips is low (if there is any demand at all). The fee is then in the order of 0.00% - 0.3% on an annual basis. By the way, Saxo applies a minimum fee for lending at all. At the other end of the spectrum, there are also securities that have a lending fee of (tens of) percent per year; these are called 'specials'. These are mainly companies where opinions in the market differ widely and where market participants are prepared to pay a lot of money to borrow these securities.
The proceeds are calculated on a daily basis and, after deduction of costs, are divided fifty-fifty between the investor and Saxo. Returns are paid monthly.

Example yield

Mr. Johnson has 5,000 shares of ABC that are quoted at USD 10.50. There is demand for the shares in the lending market and the investor's fee (after costs) is 1.75% on an annual basis. Mr. Johnson decides to lend out the shares. The yield is calculated as follows: (USD 10.50 * 0.0175 * 5,000) = USD 918.75 annualized revenue for Mr. Johnson. Per month, this is USD 918.75 / 12 = USD 76.56.
(This example assumes the shares have been lent at the same rate for the entire year.)

Why are you sharing the proceeds with Saxo?

Saxo not only arranges everything for you but also takes the risk. You lend your securities to Saxo, receive collateral worth 105%, and so the chain is clear (and closed) for you. Saxo, in turn, enters the 'lending circuit' where Saxo is the counterparty of professional borrowers. Saxo also receives collateral but has to administer, execute, and monitor the whole process. Unlike a number of discount brokers, Saxo is extremely transparent about its Securities Lending activities and pays a fee to the client. Firstly, it is up to the customer whether or not to participate in Securities Lending. No customer joins automatically because it works through an opt-in. In addition, there is clear communication from the outset about the sharing of proceeds. By enabling Securities Lending, Saxo has therefore created a win-win situation for both the customer and Saxo.

What are risks?

The main risk is that the borrower is unable to deliver the borrowed securities. At that time, the collateral already provided by the borrower is sold by the lender, and the securities are repurchased on the market from the proceeds. This is also why the collateral is greater than the value of the lent securities. Saxo is always the borrower of your securities and makes 105% collateral available in case Saxo goes bankrupt. The interests of our clients are represented by the foundation “Stichting Zekerheden Agent” to ensure that the collateral is collected collectively. From the proceeds, the loaned securities - to the extent that these have not already been delivered back by the borrowers of Saxo - can be repurchased for you.

This foundation is separate from Saxo but does have a lien on Saxo’s collateral account. This is a property right and has priority over other creditors of Saxo. Daily additions and withdrawals of collateral from your account are therefore not necessary.

Psychological obstacle

There are investors who reject securities lending in advance because they do not want to give hedge funds the opportunity to push a security sharply lower because they are going short. The question is whether this argument is sound.

Buying or not buying a share is based on vision. The buyer thinks the stock can continue to rise; the seller does not. In this case, you think that the share can rise, the hedge fund thinks it will fall. The question now is whether you, as a shareholder, are sufficiently convinced of your vision. After all, if it is a good company that is undervalued, even a hedge fund will not be able to push it lower. A long share position that hedge funds want to go short, therefore, requires extra strong conviction of your own vision on the share. But there is also a very real chance that the selling party sees it as part of a more complex, comprehensive strategy. In that case, going short in ABC share by the hedge fund is nothing more than a hedge on another position. So this does not mean that it is a ‘bad’ share.

An example of a hedge strategy Hedge fund QQQ expects the tech sector in America to do well. Their favourite stock in the sector is TechUp. They will go long on this stock. To counterbalance this long position, they go short TechDown. This reduces the total market risk of this position. The expectation is that in a rising (and sideways moving or falling) market, TechUp shares will always outperform TechDown. With this combined long/short position, they only express the relative expectation that TechUp has more potential than TechDown.  How does the allocation work? It all starts, of course, with the demand from the market for shares to be borrowed that Saxo clients have available. An automated, random procedure is used to determine which clients may fill the demand from the market.

See the following example: There are 29 clients with ABC shares in their portfolios,
totaling 503,000 shares. Of the 29 clients, 26 made their shares available to lend for a total of 478,000 shares. There is market demand for 75,000 shares. Via an automated, random procedure, customers are designated who are 'allowed' to lend the shares. Scenario 1: So it may be that Mr. Jansen, with 100,000 shares of ABC in his portfolio, is appointed and he alone can fill the demand. Scenario 2: It is also possible that Mr. Pieterse, with 2,000 shares, is appointed first, with Mrs. de Boer with 1,000 shares second, Mr. de Lange with 357 shares third and so on. In scenario 2, the demand for 75,000 shares may therefore be filled by several clients with relatively small positions. The allocation cannot be determined in advance because this happens randomly.

How do you get started?

You can activate stock lending in your account via the platform. Read more about how stock lending works in Saxo and compensation, you may get from some stocks.


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