What is behind a Securities Borrowing and Lending transaction?
The secondary market is defined as a marketplace where financial instruments that have already been issued are bought and sold. These securities include futures, options, Bonds, MTNs, Bank Guarantees and SBLCs which are sold to investors.
Important players in the secondary market are retail investors and licensed financial intermediaries like mutual funds, insurance companies, banks, non-banking financial companies, security dealers and licensed brokers.
Investors maintaining securities accounts utilize methods to generate and maximize income of securities. Investors holding or buying securities engage in lending such securities to market players who are in need of collateral for a specific term.
An association represents the common interests of securities lending and financing market participants across Europe, Middle East and Africa. Its member firms include institutional investors, asset managers, custodial banks, prime brokers and service providers. They provide the legal framework for lending and borrowing securities.
In a Securities Borrowing and Lending transaction, a borrower is in need of additional collateral to satisfy the lending guidelines of a client’s (borrower’s) bank. The bank providing the loan to the client actually determines the required rating of the securities that may be acceptable to back up a loan. When starting the process and to obtain an offer, the client provides details of the requirements for high, or very high rated securities.
Once there is a basic understanding of a borrower’s needs and an agreement about very specific publicly listed and traded securities that should be utilized, the lender will go on the secondary market and acquires exactly these securities.
Since a borrower would not have a benefit if he himself would buy the securities and pays the full price, the lender buys the securities as a form of investment and places the security in his own securities account. Based on these specific securities, the lender then issues a bank guarantee instrument (BG or SBLC) which will be backed up by exactly these securities that have been purchased for the borrower’s transaction.
By lending securities, the lender profits receiving an annual lending fee, by cashing in on securities’ bonuses and interests or a possible increase in value. So this is an attractive business model and an extremely interesting additional stream of income for a lender.
A lender generally does not own the required securities the borrower requires, but acquires them for a specific borrowing and lending transaction with a client. Cashing in on a lending fee, bonuses and interest a specific bond may offer can make this a very attractive transaction for a lender. At the same time, the borrower receives the exclusive beneficial use of the securities for his credit enhancement.
So it is a win-win situation for both parties, but not without risks to the lender. The primary risk of securities lending is the borrower default risk. Since the process involves lending securities, there is a risk that a borrower fails to return a borrowed stock or bond or the BG or SBLC prior maturity of the lending agreement. This is the reason why only qualified companies and receiving banks can be acceptable for this kind of a transaction. A detailed application with Client Information is required to pre-qualify a borrower and his bank.