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Securities lending is critical to enhance the optimal functioning of securities markets by adding liquidity and to support trading activities and strategies in all major markets.
Securities lending adds liquidity and efficiency to the securities markets and supports trading activities and strategies in all major markets. Securities lending provides lenders (such as pension and other institutional funds) with low risk yield enhancement, while enabling borrowers (such as stockbrokers or hedge fund managers) to cover failed or short sale trades, hedge risks and conduct arbitrage in the market.
WHAT IS SECURITIES LENDING?
Securities lending is an investment strategy in which investors make short-term loans of securities in their portfolios for a fee. Lenders engage in securities lending to generate revenues and are thereby able to earn an incremental return on their portfolios.
From the perspective of a pension or institutional fund (the lender), there are two critical components: (1) the loaning of a security to an institutional counterparty (the borrower) in exchange for cash collateral and a fee and, (2) the investment of the cash collateral.
The asset owner or lender can elect to enter a transaction in which it lends shares to a borrower. The borrower may be motivated to take a position in the security in order to cover a trade, add liquidity to an inventory or sell short the position. In exchange, the asset owner or the lender receives cash collateral in excess of the market value of the equities lent. The asset owner or lender will reinvest the cash collateral to produce further income. Thus, securities lending can be an additional source of additional revenue to the asset owner or lender.
BENEFITS OF SECURITIES LENDING
- Is crucial to the optimal functioning of the securities markets in South Africa;
- Increases market liquidity in tightly held equities and bonds, reducing the costs of adjusting portfolio holdings;
- Is crucial to the optimal functioning of the listed and Over-The-Counter (OTC) derivatives markets in South Africa;
- Provides borrowers and lenders with effective hedging techniques against market downturns;
- Enables arbitrage strategies that ensures that futures and cash prices on the JSE move in tandem;
- Facilitates effective and efficient settlement of equities and bonds through Strate;
- Enables additional revenue by way of fees paid to the asset owner or lender.
WHO ARE THE MONEY PARTICIPANTS?
Each securities lending transaction requires a lender and a borrower. In addition, the securities lending transaction involve one or more intermediaries or facilitators, often acting as agent for the lender or borrower or as principal.
- Pension and institutional funds;
- Investment managers;
- Life Insurance companies.
- Prime brokers;
- Hedge funds;
INTERMEDIARIES / FACILITATORS
- Agent banks (such as Standard Bank, FirstRand, ABSA, Nedbank, Investec etc);
- Agent investment managers and Life Insurance companies (such as Sanlam, Old Mutual, Metropolitan);
- Agent stockbrokers (such as Macquarie Securities South Africa).
The collateral provided generally must have a greater value than the value of the loan. Loans are marked-to-market on a daily basis to value the loan on current overnight prices and top-up collateral may be called for (or excess collateral may be returned). The lender returns the borrower’s collateral on return of the loaned securities by the borrower. All methods of taking and providing collateral are approved by the credit committee and risk committee of each lender (or agent thereof) on a client-by-client basis.
Collateral typically consists of one or more of the following:
- Bonds or other debt instruments;
- Equity securities.
The asset owner or lender will face two principal sources of risk in securities lending transactions: (1) the risk that the borrower will not be able to return the loaned securities in a timely manner due to illiquidity in the market or borrower default and, (2) the risk associated with investment of the collateral. Fortunately, there are measures to mitigate these risks, namely over-collateralization of the lent securities, stringent counterparty due diligence, and conservative collateral investment policies.
Because of the collateral requirement, securities lending has generally been viewed as an activity with little risk to the asset owner or lender. Nonetheless, in 2008, many offshore asset owner or lenders experienced significant losses related to their securities lending activities. These losses occurred because of significant declines in the value of the securities purchased with the cash collateral, and not from the practice of securities lending activities itself.
The Johannesburg Stock Exchange (JSE), Financial Services Board (FSB), South African Reserve Bank (SARB) and the South African Securities Lending Association (SASLA) all agree that securities lending adds liquidity and efficiency to the securities markets and supports trading activities and strategies in all major markets.
If the risks to the asset owners or lenders are managed properly by prudent collateral management, securities lending offers asset owners or lenders low risk yield enhancement to their portfolios while assisting the securities markets to operate optimally.
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