Securities lending is the act of loaning a stock, derivative, or other security to an investor or firm.
Understanding securities lending
In a securities lending transaction, the borrower provides collateral to the lender in the form of cash or other financial instruments. This collateral is valued slightly higher than the borrowed security to protect the lender against market fluctuations. The borrower pays a fee to the lender for the duration of the loan. The fee amount depends on the market demand for the specific security.
Short selling is the primary reason this practice occurs. When Elephants want to short a stock, they must first locate and borrow the shares before selling them on the open market. The goal is to buy the shares back at a lower price and return them to the lender. Market makers also borrow securities to cover temporary shortages and ensure their trades settle on the required dates.
Large institutional investors, such as pension funds and mutual funds, are the typical lenders in these transactions. They use securities lending to generate additional income on their long-term holdings. Prime brokers usually facilitate these arrangements. They connect the institutions holding the securities with the traders who want to borrow them.
During the loan period, the borrower receives any dividends or interest payments distributed by the security. The borrower is obligated to pass these payments back to the lender. Voting rights are transferred to the borrower, meaning the original lender loses the ability to vote on corporate actions while the security is out on loan.
Example
An Elephant trader believes the stock price of Savannah Peanuts Ltd. is going to drop following a poor harvest report. The Elephant borrows 1,000 shares of the company from an institutional pension fund and provides cash collateral in exchange. The Elephant sells the 1,000 borrowed shares immediately at the current market price of $50 per share, taking in $50,000. A month later, the stock price falls to $40 per share. The Elephant buys 1,000 shares on the open market for $40,000 and returns the shares to the pension fund. The Elephant keeps the $10,000 difference, minus the borrowing fees paid to the pension fund.