What is securities lending?
A securities lending arrangement is an arrangement under which a holder of securities agrees to provide its securities to a borrower for a specified period of time, with an associated agreement by the borrower to return equivalent securities at the end of an agreed period. Loans are typically executed under standardised agreements, which give the borrower full title for the term of the loan. Under such agreements, the lender typically charges a fee for the loan and requires that the borrower post collateral. The lender also typically reserves the right to recall the securities with a specified period of notice prior to the end of the loan period (typically based on the standard settlement period in the market - three days in Australia).
What are the reasons for borrowing and lending securities?
There are several reasons for borrowing and lending securities. In the Australian equities market, the following are the most common reasons for borrowing securities:
- Short selling - if a trader has sold securities short, it must borrow those securities in order to fulfil its settlement obligation in the securities settlement system. In Australia, this requires that the seller be in possession of securities to deliver to the buyer three days after trade date. Short selling may reflect an outright directional view of the price of a security, or more commonly a view of relative prices.
- Hedging - a derivatives market-maker, for instance, may need to sell securities that it does not own to hedge an equity-linked derivatives position. Similar to a short seller, the market-maker must then borrow securities to meet its settlement obligation.
- Arbitrage - a trader may need to sell securities short against an offsetting derivatives position to take advantage of dislocation between cash and derivatives markets. A common strategy here is 'index arbitrage' where offsetting positions are taken in a basket of securities and in the relevant equity index futures contract.
- Fails-driven borrowing - if a broker or custodian has a settlement obligation but does not have the securities in place (perhaps due to operational problems or because its client has not made adequate arrangements to deliver the securities), it may borrow securities to ensure that it can meet its obligation and thereby avoid incurring settlement fail penalties imposed by the securities settlement facility.
From the point of view of the lender, the motivation of securities lending may be to earn an incremental return on securities held in its portfolio. Another motivation may be to lend securities to raise cash to meet funding needs.
Will the outstanding loaned position in a security be equivalent to the short interest in that security?
This is unlikely. As noted above, there are several reasons for engaging in securities lending activity. Some of these relate to a need to cover a short-sold position in the security, though this may reflect arbitrage or hedging activity, rather than directional short-selling activity. Others, such as fails-driven borrowing, or financing-driven lending, are not motivated by short selling. Even if short selling were the only motivation to borrow securities, the term of a securities loan and a short-sold position may differ, and the activities of intermediary brokers (e.g., cases in which A lends to B who on-lends to C) would make the gross outstanding loaned position an imperfect proxy for short interest. In this regard, the reports detailing the net outstanding borrowing and lending positions, which exclude intermediary lending activity, are likely to more closely reflect the net demand for borrowed securities.
Securities Lending reporting
A number of reports have been introduced which aim to improve the transparency of securities lending in the Australian Equities Market.