Konstantinova K.V., Moiseieva F.A.

Donetsk National  University of Economics and Trade named after Mykhailo Tugan-Baranovsky

The mechanisms of securities lending

There are different definitions of securities lending, namely, securities lending– the temporary transfer of securities, usually on a collateralized basis – is a major and growing activity, providing significant benefits for issuers, investors and traders alike.

Or securities lending is legal and clearly regulated in most of the world's major securities markets.

Most markets mandate that the borrowing of securities be conducted only for specifically permitted purposes, which generally include:

· to facilitate settlement of a trade,

· to facilitate delivery of a short sale,

· to finance the security,

· to facilitate a loan to another borrower who is motivated by one of these permitted purposes.

The initial driver for the securities lending business was to cover settlement failure. If one party fails to deliver stock to you it can mean that you are unable to deliver stock that you have already sold to another party. In order to avoid the costs and penalties that can arise from settlement failure, stock could be borrowed at a fee, and delivered to the second party. When your initial stock finally arrived (or was obtained from another source) lender would receive back the same number of shares in the security they lent.

We must say that the word ‘lending’ is in some ways misleading. Under English [and Australian] law, the transaction is in fact an absolute transfer of title (as in a sale) against an undertaking to return equivalent securities. Usually the borrower will collateralize the transaction with cash or other securities of equal or greater value than the lent securities, in order to protect the lender against counterparty credit risk.

Some important consequences arise from the nature of securities lending transactions: under English [and Australian] law, absolute title over both lent and collateral securities passes between the parties. Therefore, all these securities can be sold outright or on-lent, which is commonplace and an intrinsic part of the functioning of the market.

The borrower is entitled to the economic benefits of owning the lent securities (e.g. dividends), but the agreement with the lender will oblige it to make (‘manufacture’) equivalent payments back to the lender.

Scheme of mechanism of securities lending

A lender of equities no longer owns them and has no entitlement to vote. But it is still exposed to price movements on them, since effectively the borrower can return them at a pre-agreed price. Lenders typically reserve the right to recall equivalent securities from the borrower, and will exercise this option if they wish to vote. Borrowing securities for the specific purpose of influencing a shareholder vote is not regarded as acceptable market practice in the UK.

We should underline that securities lending & borrowing is often required, by matter of law, to engage in short selling. In fact, recent regulation in the United States required that, before short sales were executed for 19 specific financial stocks, the sellers first pre-borrow shares in those issues. This caused securities lending volumes in these 19 issues to double The SEC is currently evaluating whether to extend such a rule to the wider market.

The principal reason for borrowing a security is to cover a short position. As you are obliged to deliver the security, you will have to borrow it. At the end of the agreement you will have to return an equivalent security to the lender. Equivalent in this context means fungible, i.e. the securities have to be completely interchangeable. Compare this with lending a ten euro note. You do not expect exactly the same note back, as any ten euro note will do.

Thus, securities lending is likely to include improved market liquidity, more efficient settlement, tighter dealer prices and perhaps a reduction in the cost of capital. The scale of securities lending globally is difficult to determine accurately, as it is an “over the counter” rather than an exchange-traded market. However, it is safe to say that the balance of securities on loan globally exceeds $1 trillion.

Literature:

1. Robert E. Wright, Vincenzo Quadrini. Money and Banking
Publisher: Flat World Knowledge, 2009.

2. Бурденко І., Пожар О. Розкриття інформації про банківські ризики у фінансовій звітності // Вісник Національного банку України. – 2006. - №7. – С. 52-55.