Stock Lending and Borrowing is an important activity in equity and bond markets. As per BBA,UK following are benefits of securities lending and borrowing:
• Increase the liquidity of the securities market by allowing securities to be borrowed temporarily; thus reducing the potential for failed settlements and the penalties this may incur.
• Provide extra security to lenders through the collateralisation of a loan
• Support many trading and investment strategies that otherwise would be extremely difficult to execute
• Allow investors to earn income by lending their securities on to third parties
• Facilitate the hedging and arbitraging of price differentials
Securities lending describes the common market practice by which securities are transferred temporarily from one party (the lender) to another (the borrower) with the borrower obliged to return them (or equivalent securities) either on demand or at the end of any agreed term.
Need for securities lending and borrowing arises for multiple reasons. One of the prime reasons for securities lending and borrowing is short selling of securities. Short selling of securities means selling securities which are not owned by an institution or individual. Since securities are not available with the institution, it creates need for securities lending and borrowing.
Let us understand the process of securities lending and borrowing through a simulating example which is as follows:
ABC Hedge Fund short sells 10000 shares of Picago Limited at price of $1000 each. This is done on 01-Jan-2012. Since it does not have securities, it approaches an Investment Manager Zenith Ltd. for the arranging the shares. The Investment Manager says that it will charge 75 bp for arranging securities, which is acceptable to ABC. Investment Manager then approaches Pension Fund Zooka Limited which asks for 115% collateral of the value for lending of securities with following hair cuts 1) Cash-Nil, 2) GSec- 2%, 3) AAA rated Bonds 7% and 4) Junk Bonds 30%.
It says that it will charge 3% on securities lent as fee and will charge additional 50 bp beyond 30 days. ABC agrees for this as well. ABC offers following cash and securities as collateral:
1) Cash= $40, 00,000
2) Gsec= $ 20, 00,000
3) Junk Bonds= $ 80, 00,000 ( The value falls by 12% on 30th day)
ABC after short selling shares buys the shares from market at price of $935 and returns security after 35 days to Zooka Ltd.
1) Gains of ABC, Zenith Limited and Zooka Limited
2) Identify value of collateral,
3) after 30, day's additional collateral to be given.
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