Did you know that when you buy or sell a security, it may not be the actual security transferred between buyer and seller? Securities lending is often used by traders who want to take advantage of price differences between related securities without owning them.
What is securities lending?
In the simplest terms, securities lending is temporarily transferring ownership of a security from one party to another. The borrower then sells the security on the open market, hoping to profit from a price difference between the purchase price and the eventual sale price. When it comes time to return the security, the borrower repurchases it on the open market and returns it to the lender.
How does it work?
Securities lending is often used by traders who want to take advantage of price differences between related securities without actually owning them. For example, let’s say you think that stock A will increase in value relative to stock B. However, you don’t want to buy stock A outright because you think there’s a chance that your prediction could be wrong, and you would then be stuck with an asset that’s lost value.
Instead, you could borrow stock A from a lender, sell it on the open market, and then buy stock B. If your prediction was correct and stock A does indeed increase in value relative to stock B, you’ll make a profit when you buy back stock A and return it to the lender. Of course, if your prediction is wrong and stock A decreases in value relative to stock B, you’ll take a loss.
There are two main types of securities lending- intraday securities lending and overnight securities lending. Intraday securities lending refers to transactions that are completed within the same day. On the other hand, Overnight securities lending involves borrowing security for one day or longer.
In both cases, the borrower must put up collateral to secure the loan. The collateral is typically in the form of cash or another security, and it must be worth at least as much as the value of the security that is being borrowed.
Why engage in securities lending?
There are a few reasons someone might want to engage in securities lending. First, as we mentioned, it allows traders to take advantage of price differences between related securities without actually owning them.
Securities lending can provide income for investors looking for alternative revenue sources. When you lend your securities to another party, you usually receive a fee for doing so, and this fee can be a fixed amount or a percentage of the value of the security. Securities lending can help to increase the liquidity of a security. When more people can trade security, it becomes easier for buyers and sellers to find each other and complete transactions.
Securities lending can also be used to hedge against risk. For example, if you own stock in company A and think there’s a chance that it might decrease in value, you could lend your shares to another party and receive collateral in the form of cash.
If company A’s stock does indeed go down in value, the loss will be offset by the gain in the value of the cash collateral. Of course, if company A’s stock goes up in value, you’ll miss out on the potential profits.
What are the risks of securities lending?
There are a few risks to be aware of if you’re considering lending your securities. First, there’s the risk that the borrower will not return the security. It is known as counterparty risk, the most significant risk associated with securities lending.
To mitigate this risk, lenders usually require borrowers to post collateral as cash or another security. The collateral must be worth at least as much as the value of the security that is being borrowed. Even if the borrower defaults on the loan, the lender will still have the collateral to cover their losses.
Another risk to consider is market risk. It is the risk that the price of the security you’ve lent will go up while the borrower is holding it. If this happens, the borrower will make a profit while you miss out on the potential gains. To offset this risk, lenders typically charge higher fees for securities more prone to price fluctuations.
Finally, there’s the risk of reinvestment risk. It is the risk that interest rates will change while the borrower is holding your securities, and as a result, you will miss out on the opportunity to reinvest your collateral at a higher rate.