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Securities Lending Frequently Asked Questions

	What are the most important things to consider when establishing or analyzing a securities lending program?
	Does lending my securities help drive down the price of those securities?
	Briefly summarize the steps that take place in a securities lending transaction.
	What are the advantages and disadvantages of lending through a custodian?
	What are the advantages and disadvantages of lending exclusively through a principal?
	What are the advantages and disadvantages of lending through a third party agent?
	What has contributed to the industry’s remarkable growth?

	What are the most important things to consider when establishing or analyzing a securities lending program?
We believe that the most important considerations are: Creditworthiness of counterparty Proper risk controls and operational efficiency Maintaining appropriate levels of collateralization through daily marks-to-market Clearly defined lending and reinvestment guidelines Execution of appropriate legal agreements Means to evaluate or benchmark your lending program

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	Does lending my securities help drive down the price of those securities?
While occasionally some market participants view securities lenders as enablers of short selling with supposed ill effects on the market, in fact securities lending is embraced by virtually every central bank and stock exchange as a significant contributor to liquidity and therefore stability of stock prices. A demand will exist for securities lending as long as a demand exists for securities. The need will remain regardless of whether or not a given institution chooses to lend securities. In the long run, the market value of an equity security should not be affected by the lending of that security. Temporary buy / sell imbalances will not affect long term stock prices. While a bit dated, for a sophisticated view of securities lending see the IOSCO report.

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	Briefly summarize the steps that take place in a securities lending transaction.

The following steps take place in a securities lending transaction in a traditional agency lending cash collateral model: A borrower (e.g., a broker-dealer or bank) locates a specific security. A lending agent negotiates the terms of the loan with the borrower to include price, rebate rate and in some cases, duration. For loans of US equities, cash collateral is delivered at 102 percent of the market value of the security; loans of US fixed income securities, cash collateral is delivered at 102 percent of the market value of the security to include accrued interest to the lending agent. In lending programs involving loans of non-US securities, the margin required on collateral is 105 percent. Securities are delivered to the borrower upon receipt of collateral. Cash collateral may be invested in a separately managed account, in an investment pool managed by the agent or in an external fund typically in short-term instruments within the investment guidelines of the lender. A negotiated portion of the cash collateral interest earned on the reinvestment is paid to the borrower as a rebate. Out of the remaining portion of the cash collateral interest earned, the lending agent is entitled to a percentage as negotiated between the lender and the lending agent. The market value of the loan outstanding is priced and marked to market daily to ensure full collateralization Steps that take place in a securities lending transaction involving securities as collateral: A borrower (e.g., a broker-dealer or bank) locates a specific security. A lending agent negotiates the term of the loan with the borrower to include the price, loan premium fee and in some cases duration. For loans of US equities, approved securities collateral is delivered at 102 percent of the market value of the security; loans of US fixed income securities, cash collateral is delivered at 102 percent of the market value of the security to include accrued interest to the lending agent, fixed income securities held as collateral is also mark to market to include accrued interest. In lending programs involving loans of non-US securities, the margin required on collateral is 105 percent. Securities are delivered to the borrower upon receipt of collateral. Borrower pays a loan premium fee to the lender. Out of the fee paid to the lender, the lending agent is entitled to a percentage as negotiated between the lender and lending agent. The market value of the loan outstanding and securities collateral are priced and marked to market daily to ensure full collateralization. Our securities lending transactions follow a similar process, with the differences lying in the first few steps. Initially, rather than locating a security, the borrower bids for securities via eSecLending’s auction platform. The negotiation, listed in step 2 above, does not take place in our model.

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	What are the advantages and disadvantages of lending through a custodian?

Custodial lending offers a conservative and streamlined means of combining custody, securities lending and cash management through one provider on a “one-stop shopping” approach. One of the key disadvantages of using a custodial lender, however, is the concern that the lender will get “lost in the crowd” and become just another member of a potentially large queue waiting to lend their assets. In order to promote a fair and equitable distribution of securities across all potential lenders, a custodial lender must develop a methodology to allocate the demand for securities. This usually takes the form of a “queue”, whereby all lenders’ assets are bundled together, and an algorithm is used to determine the size and order of distribution when demand for a particular security arises. Proportionately, the size of the individual loans per borrower, and the resultant earnings, may be significantly lower than the size of loans and revenue that can be earned in an auction process. An auction provides lenders with greater transparency and price discovery for the lendable assets. The auction helps determine the optimal route to market whether it’s through exclusive arrangements or daily discretionary lending. Also, for lenders with large attractive assets, receiving a fair portion of activity in a pooled environment may only earn average returns for their funds. Those same “unders” could earn above average returns when lending outside of a custodial program.

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	What are the advantages and disadvantages of lending exclusively through a principal?

Lending securities through an exclusive principal program provides an efficient means of generating a guaranteed stream of income on a portfolio or portion of portfolio, for a fixed period of time. Exclusive principal programs provide the borrower(s) with the exclusive right to borrow from a portfolio. This exclusive supply is very attractive to borrowers and allows them greater trading flexibility, knowing that they have a guaranteed supply of securities at hand. Borrowers are often willing to pay a premium over what a lender otherwise may be able to earn in a traditional agency program in order to lock up attractive supply via an exclusive. In an exclusive principal program the lender selects the borrower(s) at the outset of the program. The lender has the opportunity to structure the program according to their specific credit requirements and lending limits, and can customize the program to suit their specific timeframe and risk parameters.

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	What are the advantages and disadvantages of lending through a third party agent?

An independent third party agent provides a lending functionality that can range from a traditional stock-by-stock lending program, to an exclusive principal lending arrangement, and everything in between. They are able to develop and customize lending programs without the constraints often imposed on large, full-scale custodial lending operations. Third party agents provide a valuable resource for lenders of all sizes. Smaller lenders may find third party agents provide more direct and more specialized support to a portfolio that might otherwise get lost in a traditional custodial lending program. Larger lenders may find third party agents able to devote dedicated resources to customizing and structuring a program to fit their specific lending needs. One of the disadvantages of using a third party agent is the perceived lack of market presence and scale to handle a major lending operation. This is becoming less of an issue, however, with the continued growth in the number of third party agents and their greater acceptance in the marketplace by the dealer community. Third party agents have grown to fill a niche in the lending markets. Many major lenders are now expanding their lending activities to include a combination of custodial lending, exclusive principal programs, and third party agents. The successes of third party agents continue to fuel even greater expansion of this sector, leading to more and more lenders adding third party agents to their roster of securities lending providers.

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	What has contributed to the industry’s remarkable growth?

Globalization Leading firms now active in as many as 27 markets Liberalization of market and entrance of new participants has increased competition and loan activity Consolidation Mergers have created financial supermarkets offering multiple types of lending structures and functions within each organization Liberalization of market and entrance of new participants has increased competition and loan activity Increased demand to borrow securities Increase in hedge fund activity has increased demand to borrow securities Increase in sophisticated proprietary trading arbitrage strategies by broker-dealers and banks Growth of market neutral and total return strategies Unbundling of securities lending Institutional investors are realizing bundling of securities lending with other custody services is not always optimal More programs moving towards portfolio auctions, third party agents and exclusive principal relationships Improved risk management techniques Application of investment industry disciplines Leveraging technology to reduce operational and legal risks

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