Prime brokers offer a variety of services to investors, from providing credit to clearing trades. One important service offered is known as Securities Lending. In Part One of this article, we’ll look at the contractual and collateral rules pertaining to Securities Lending.
As an investor or hedge fund, you may wish to borrow shares for a variety of reasons, such as shorting the stock or hedging a long position. An executed Securities Lending Agreement is the documentation required before shares are loaned.
The Securities Borrower (the investor) and Securities Lender (the prime broker) negotiate the lending agreement, which then governs subsequent Stock Loan Transactions. The borrower and lender agree upon a loan, including number of shares, borrow rate (fee or rebate), and collateral type and amount. The trade’s dividend percentage is also agreed; this is based upon the domicile country of the stock and the tax withholding as declared by the tax treaty between the stock’s domicile county and the Lender’s country of origin. The shares are lent to the borrower, who in turn pledges collateral (usually cash) to the lender. Two cash flows can then result:
- The Stock Borrower pays a borrow fee to the Lender. The Lender can change this fee if a stock, for example, becomes hard-to-borrow. The fee is usually paid monthly via a Fee Statement sent from lender to borrower.
- The Stock Lender pays interest (rebate) to the Borrower on the Borrower’s cash collateral. This is usually paid monthly via a Rebate Statement sent to the lender from the borrower.
These two flows can be netted together to form a single flow defined as borrow fee paid to the stock lender minus the rebate on cash collateral paid by the stock lender. Note that the stock borrower either pays a fee or receives a rebate, depending on the collateralization. If cash is used as collateral, the borrower receives a rebate that will be less than the income the lender earns on investing the cash. For non-cash collateral, the borrower pays a fee. The net fee/rebate is collected/paid monthly. Payment is normally expected within 30 days of billing (â€œnet 30â€ terms).
The Securities Lending Agreement will state that upon loan of a security, the borrower must pledge acceptable collateral for the borrowed securities. If the lender fails to deliver the loaned security, the borrower may demand the return of the collateral if prepaid. Conversely, if the borrower fails to deliver collateral to the lender, the lender has the right to the return of the loaned security. The important features of collateral include:
- Acceptable Collateral: Usually cash, government securities, or letters of credit from US banks, or certificates of deposit (though not widely used). There may be reference to foreign sovereign debt and currency provided it is pledged for securities borrowed of the same country/currency.
- Margin Required: Minimum requirement is 100% from a regulatory standpoint; however, most agreements will state 102% for U.S. securities and 105% for foreign securities.
- Lender’s and Borrower’s Rights to Collateral: Lenders may at their own risk, invest the cash collateral, but must guaranty the principal to the borrower. If the lender is a broker dealer, the lender may use the securities pledged as collateral to pledge to another lender, sell or lend. Upon returning the borrowed securities, the lender must return the collateral to the borrower.
- Right of Substitution: If agreed, the borrower has the right to call back and replace the posted collateral with a different, albeit similar, collateral provided the new collateral value satisfies the required margin. This may be limited to a specific number of substitution events.
- Mark to Market: in order to maintain the required margin, trades will be marked to market based on the previous business day’s closing market price as quoted in the exchange in which it’s traded. For U.S. Government Securities it is the average of the bid and ask price and the price is to include accrued interest from the last coupon payment date. If the security is not quoted in an exchange, the usual accepted source is the Wall Street Journal highest bid quotation, or other similarly nationally recognized pricing source. For foreign securities, the market prices are converted to the base currency of the trade (usually USD) based on foreign exchange rates for the current business day.
In Part Two, we’ll explore fees, dividends and defaults as they relate to Securities Lending.
Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles appear on eHow and on numerous other websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.