I have a question from work about securities lending - it’s mainly related to the basic structure that securities lending programs are set up. If anyone had experience in securities lending, please share your comments… So I got to know that there’re the cash collateral and non-cash collateral scenarios for securities lending. That being said, as a borrower you can use cash or securities (non-cash) as your collaterals to give to the agent, in order to borrow the shares of stocks that you would like to sell short on the market. However, I’m confused as to what the borrower’s motivation is to choose the non-cash collateral over cash collateral. What’s the incentive? What’s the advantage? What’s the downside? - of non-cash collaterals? Suppose that: Scenario 1 (cash collateral): the agent invests all of the borrower’s cash collateral in a high-quality fixed income security, and then capture the investment yields from the fixed income security as part of the agent’s profit. In the end, the cash collateral is returned to the borrower, and the borrower also gets profit from the short sale. agent profit = investment yield on cash collateral borrower profit = short sale Scenario 2 (non-cash collateral): the agent gets the borrower’s high-quality fixed income security as the collateral, keeps them at hand, and receives agent fees from the borrower as the agent’s profit. In the end, the security collateral is returned to the borrower, but the agent keeps the yields from the high-quality fixed income security, and the borrower gets profit from the short sale. agent profit = securities yield + agent fees borrower profit = short sale - agent fees My questions are, looking at the above two formulas from the two scenarios, from the borrower’s perspective: 1) Why would borrowers choose the 2nd scenario over the 1st scenario? 2) Do the borrowers usually also pay agent fees or make some sort of sacrifice in the 1st scenario? 3) Which method do the lenders prefer? Thanks a lot in advance. Please correct me if there’re any mistakes in my understanding of the lending structure.
anyone?
2.1) you would accept the non-cash collateral if you needed it to say cover a short position. You’d deliver the collateral and get cash then later when the original lender wanted his collateral back, you’d go in the market and buy a similar asset and deliver that.
it depends on the liquidity position of the borrower of the security. If they post cash to the sec lender to cover margin, they have to pay their marginal cost of cash and the sec lender may/may not pay a small return (think something less than fed open). If non-cash collateral is pledged, such as Treasuries or an L/C, the borrower earns something on their asset (the treasury) or does not have to use cash (an L/C) In the case of the Treasury, the sec lender can repo out the Treasury for cash and therefore monetize the collateral.
The payoffs aren’t quite correct. In the cash scenario (1), the agent profits on the spread between what they are earning on the cash reinvestment (money market yield typically) and the rebate rate paid back to the borrower. The rebate rate is negotiated as part of the loan transaction and represents the cost of funding for the borrower minus the desirability of the security being borrowed (the harder to borrow the security, the lower the rebate rate). In a non-cash trade (2), a flat fee is negotiated on the loan. The agent delivers the security in exchange for collateral (really can be anything from treasuries to equity, depending on what is negotiated). The borrower will still receive all coupon payments from the collateral at the end of the trade (or they may settle up periodically depending on the length of the loan) and the agent receives only the pre-determined fee. The agent does not get to keep the coupons/dividends from the collateral they are holding…just like the borrower must return any coupons/dividends from the securities they borrower back to the agent. In both scenarios, the borrower’s payoff comes from whatever they want to use the borrowed security for…short sale, sale fail coverage, market making, etc. Motivations for which is preferable can vary. Borrowers typically prefer to deliver non-cash because it’s cheaper to deliver idle assets than to use up precious cash. Lenders typically prefer cash collateral (assuming they are willing to take a little risk on the reinvestment) because the total spread on the transaction is wider. Currently, non-cash is more of a market convention in Europe than in the US. There are some regulations in the US that restrict the delivery of non-cash (particularly Equity) as collateral.
Thank you! This really helps a lot. Do you know if whoever brings the lender to the table spends as much effort as whoever brings the borrower to the table? Just my guess - as for the sales/marketing team working for the agent, they probably put in lots of efforts to advertise their business and attract borrowers to the agent. While on the lenders’ side, are the lenders mostly established relationships with the agent and thus will always be there and do not require much effort to be found? I suppose the team who brings the lender to the table would not share that much of a profit as the team who brings the borrower to the table? - Thanks!
I’m not sure I understand the question…generally, an agent is representing a large stable of institutional investors (many times the agent is also the custodian) and the borrower is a broker dealer representing a variety of investment managers, hedge funds, etc. Generally, the borrowers and agents already know each other because there are a few large lenders and a few large borrowers that dominate the market. Those borrowers that aren’t big enough or credit-worthy enough to do business with the large lending agents will simply go through one of the bigger broker-dealers. To be sure, the broker-dealer’s side of the trade is much more lucrative than the lender’s agent’s. For most lenders lending is an incremental return program where little risk yields little return. Plus, there is a supply/demand element. Most stocks/bonds are easy to borrow and so if the borrower can’t get them from you, they’ll get them from the guy down the street. It’s a buyers (borrower’s) market.
Thanks much. In my case, the agent (some bank) is acting as the “agent lender” who negotiates between the borrower and the lender. Would this book - Securities Finance: Securities Lending and Repurchase Agreements (Frank J. Fabozzi Series) - be a good introduction for the business?
In addition, the agent (the bank) believes that the ability to acquire borrowers is the key factor for success in this business. But I thought the ability to match lenders with the borrower’s needs is also critical? In other words, the ability to match up borrowers with lenders is not shared by everyone in the industry? I’m also interested in the supply/demand analysis - is it a fragmented market with lots of borrowers and lots of lenders? Or a market with fewer borrowers (i.e. institutional investors) and lots of lenders - which indicates that the borrowers are more powerful in the negotiations?
Yes. A shorter, simpler intro can be found on the Publications page of the International Securities Lending Association.