Securities lending involves loaning out shares in an equity investment account to borrowers, normally investment funds engaged in short selling. Loaning out your long-term equity holdings can be an effective way of improving overall portfolio yield, but as always, additional returns are paid out for taking on greater risks. The main risks as well as benefits of securities lending in Singapore are described below.
Understanding Securities Lending:
Securities lending can be defined as a temporary transfer of securities from an investor, known as the lender, to a borrower, with an agreement to return the borrowed securities at a later date. The primary motivation for engaging in securities lending is to generate additional income for the lender, who receives a fee in return for lending out their shares. This fee can help offset transaction costs, enhance portfolio returns, or provide an additional revenue stream. Normally the fee obtained by a securities lending agreement is split between the broker holding the account and the ultimate owner of the securities.
The counterparty in a securities lending agreement is normally a long / short equity fund, or another institutional investor who wants to short sell. In short sales, a trader borrows securities at the current market price, paying a small premium for the duration of the loan, and then waits for the market price to decline, buying the same securities at a lower price and returning the borrowed shares. They then profit the difference between the loaned price and lower market price less the premium. Since losses are theoretically unlimited if the price increases, short selling is considered an advanced trading strategy.
Mechanics of Securities Lending:
The lenders are typically institutional investors, such as pension funds, mutual funds, or insurance companies, who hold substantial equity portfolios. By participating in securities lending, these lenders can leverage their existing investments to earn additional income. It is also possible for retail investors with long-term equity holdings to loan out equities via their broker.
As described above, the borrowers are usually investment funds, including hedge funds or other institutional investors, seeking to borrow shares for various purposes. The most common motive behind borrowing shares is short selling, where the borrower aims to profit from the potential decline in the stock price. It is almost unheard of for retail investors to borrow securities, or engage in short selling.
Brokers and intermediaries facilitate securities lending.These may be custodian banks or broker-dealers, who act as agents between lenders and borrowers. These intermediaries ensure smooth execution of the lending process, including negotiating loan terms, collateral management, and handling transaction settlements.
Investors form a loan agreement before lending securities. This document outlines the terms and conditions of the transaction. This agreement specifies key elements, such as the duration of the loan, lending fees, collateral requirements, and borrower indemnification.To mitigate counterparty risk, borrowers are required to provide collateral to the lender. The collateral is typically in the form of cash, high-quality government securities, or other liquid assets. By providing collateral, borrowers ensure that lenders have recourse in case of default or any other adverse event during the loan period.
Benefits and Risks of Securities Lending:
The obvious benefit of securities lending is that it allows the borrower to engage in short selling, and the broker and lender receive a premium. These premiums are typically fairly small, but especially when overall equity yields are low can provide a much-needed boost to the portfolio.
Since financial markets reward participants for taking on risk, the ‘risks’ and ‘benefits’ of such a transaction are really the same thing. The premiums paid out in these contracts reimburse the borrower for two things, counterparty risk and the operational complexity of loaning out securities. Since the latter is normally borne by the broker, the premium is split between the lender and intermediary. Operationally the drafting of agreements, transfer of securities and management of positions all incur a cost, repaid by the premium, leaving counterparty risk as the main exposure.
Counterparty risk refers to the danger of the borrowing party defaulting on its debts. Investment funds can and do go bust, and activities such as short selling may even increase this risk. Since short selling involves theoretically unlimited losses, the very act of entering a short trade may worsen the financial outlook of a fund. Risk management practice on the part of the hedge fund is critical to manage these sensitive short positions when trading. Proper use of stop losses, position sizing, and the difficult-to-control factor of ‘being right’ are all important parts of short selling.
Long / short equity funds
Long / short equity funds use short sales as part of an overall strategy of market neutrality. Typically such a fund will dedicate the majority of their portfolio to long stock positions, while committing 10-15% to a number of short positions. The idea behind this is that during a market downturn, when even outperforming equities will lose value, the short positions can hedge the losses by providing profit on downwards movements. Stock selection is vital for both the long and short sides: such a fund will want to go long outperformers and short companies with financial problems or an adverse business environment. Since short sales are recorded publicly, a fund opening a large short position in a particular stock is normally taken very seriously by the broader market. Some analysts even open short positions when releasing a negative financial report on a company, which can become a serious problem for that business and its investors.
When short sales go right, they provide uncorrelated returns to the general market, making hedge funds that pull this off successfully highly profitable. But failed short positions are expensive disasters, sometimes wiping out months or more of overall returns. In a failed short position, the fund must decide whether to keep paying premiums, and possibly facing margin calls on the borrowed position, and hope for a later downturn, or to exit the position. When a fund exits a losing position their losses equal the new, higher price less the loan price, as well as any premiums paid. In a bad enough loss, this could threaten the integrity of the fund and cause investors to pull out.
For lenders, this only matters on the rare instances where the fund can no longer return the securities. This is unusual, but since there is at least a theoretical risk of a non-payment, lenders are offered a premium to mitigate the risk. It is rare for a fund to go bust, and even then lenders would have some claim to their assets in liquidation, but this is a protracted process with no guarantee of a full return.
Securities lending is a good way of improving the yield on your equity portfolio, but of course this comes with heightened risk. The actual chances of a counterparty failing and not returning your shares are very low, leading many investors to accept the higher returns. One final point to be remembered is that when securities are loaned out they cannot be sold, so this strategy is only appropriate for longer-term holdings. A short term trading account should not use securities lending, but for a portion of a retirement portfolio or similar account it may be an appropriate strategy.