What is Security Lending

Short sellers are the market’s police officers — Seth Klarman (Cornell ‘79)

You might have heard of the term short a lot. Intuitively it means selling something that you don’t own and hoping you can buy it back at a cheaper price.

But, how?

Repo is a common way, but here’s another: security lending

Definition of Security Lending

As title

Notice that if you borrow a security, you have absolute ownership of this security, including the voting right if you own stocks under certain conditions. However, borrowing security to gain an influence on the board is highly illegal.

Let’s look at an example

To cover a short position in McDonald’s (the corporate, not the drive-thru), I can borrow some McDonald’s stocks, sell them high, buy back low in the future, and return the stock.

What is this? Arbitrage!

But it’s not that simple. Security lending has specifications including:

Specification	Example
Transaction date	Sep. 12th
Term	Open
Security	McDonald's Corporation Common Stock
Collateral (if cash)	$154M
Collateral (if non-cash)	UK Gilt
Margin	5%
Price & quantity (if equity)	500k shares * McD stocks ($280/share)
Rebate fee & reinvestment rate(if cash collateral)	90bps & 120bps
Rental fee (if non-cash collateral)	70bps

Cash collateral vs Non-cash collateral

Notice that some security lending takes cash collateral whereas some take non-cash collateral. The former is common in the US, whereas the latter is more common outside of the US

What’s the difference between security lending and repo?

Quick revisit: Repo, short of repurchase agreement, is a contract in which a buyer temporarily sells a security to a seller, and promises to buy back in the future.

Both security lending and repo are secured financing transactions (SFT). But they are actually different.

	Security Lend	Repo
Purpose	Market-making, collateralizing other transactions, arbitrage	Borrow or lend cash
Security loaned	Typically equity and fixed-income	Mostly fixed income
Fee/interests	Cash: Borrower gets rebate interest; Non-cash: The borrower pays the lender a fee	Borrower earns interest on cash being loaned
Collateral haircut & substitution	A collateral haircut is typical; Collateral substitution is ok for both general and special collaterals	Collateral substitution is ok for general but not special collaterals
Dividends & interests	Dividends & interests earned on loaned security go back to the lender	Interests earned on the security go to the seller

Who are the security lenders?

They include mutual funds, ETFs, Insurance Corporations, Banks, Central Banks, etc.

Who are the security borrowers?

Hedgies (hedge funds).

Can day traders borrow/lend securities? Up to your broker.

Lending Strategy

Value lending

aka intrinsic lending. Some securities are hot, but not quite available on the market. Lenders can offer scarce and high-cost security and capture the premium.

For example, someone shortsold a stock a month ago, now he needs to give it back to the lender. What if he can’t buy one at this moment? Perhaps borrow one from another lender.

Such a strategy pays a high return, but there are not that many opportunities

Volume lending: aka general collateral (GC) lending, compromises the majority of security loaning.

It’s basically lending highly liquid collateral at a low fee.

low fee x high volume = fat returns

How does security lending generate revenue?

Fee income

The lender charges a fee. Some contracts allow the borrower to call back the security under certain conditions (e.g. collateral value is below the margin). Calling back the security definitely spooks the borrowers. To avoid spooky calling back? Pay a higher fee so the lender promises not to recall early.

It’s noticeable that passive-managed funds (e.g. index funds) are not likely to significantly change their holdings, but are likely to lend securities. In contrast to active-managed funds, passive-managed funds have to lower turnover ratio.

Collateral reinvestment income

When you get cash collateral, you don’t just put them in a piggy bank. You can use them in low-risk but high-quality investments such as money markets.

If you are a custodian bank, reinvestment would improve yield in the investment portfolio, and/or offset custody and administration costs.

Security Lending and Financial Crisis

The security lending business grew very fast right before the financial crisis (when I was 6 years old). Back then we didn’t have regulations like Basel III, so banks loved to go crazy and go stupid.

The original sin of security lending is the risk that lies in cash reinvestment. To get a higher yield, many lenders invested cash collaterals in credit market, which is risky asf. So, cash collaterals went poof in things like credit card bills and toxic residential MBS a few month later.

So here we come: bonjour Citi, here’s your garbage security that I borrowed, but where’s my cash? I mean idrgaf to the loss of value in these MBS or the mortgages beneath went default or not. I just want my cash collateral.

For this, security lending were (nearly) suspended. This business resumed in the next few years. But it’s not because banks go crazy and go stupid again, but due to positive factors like shortage of good quality collateral and quantitative easing(QEs, aka printing money).

ECON 101 tells us that less supply of good quality collateral means the prices of good quality collaterals go up. And we know, bankers don’t like being in bed with risks.

Why QE helps? When J Pow buys a bunch of high-quality liquid assets (HQLA) with his printed money, the supplies of HQLA decreases and the value of HQLA increases.