Increased returns via Securities Lending

Securities Lending (or stock lending) is a transaction where a lender; who is typically an institutional investor, superannuation fund, custody bank or similar large entity, transfers securities to a borrower; usually a securities dealer who requires the securities for settlement purpose, or a hedge fund who wants to trade (specifically short-sell) the stock. The transaction can be for a fixed or variable period of time and the lender receives collateral that is equal to a percentage of the loaned securities. Although the ownership of the securities is transferred to the borrower during the securities lending period, the lender retains the rights. Therefore the borrower has to ensure the lender receives the value of the dividends, rights issues and bonus shares. The lender does however waive their voting rights.

It is different to a CFD which is a contract to exchange the change in value of assets and liabilities between you and the counterparty, no securities need to change ownership. It is also not Short selling under the Corporations Act or ASX Market Rules. This gives certain advantages

• A bigger list of securities is available for trading. 
• Trading is more reliable with greater certainty of price because the sale does not have to satisfy the Up Tick Rule. 

The Up Tick rule is important because the sale of securities on the ASX is governed by both the Corporations Act 2001 and ASX Market Rules. The section of the Corporations Act that deals with Short Selling restricts the price at which a Short Sale may take place. ASX Market Rules also have a restriction on the price at which a Short Sale may take place. In summary 

• The price per unit in respect of the sale may not be below the price at which the immediately preceding ordinary sale was effected
• The price per unit is above the price at which the immediately preceding ordinary sale was made, unless the price at which the immediately preceding ordinary sale was made was higher than the next preceding different price at which an ordinary sale had been made.

In other words, the market price must at some point move up to the price at which the Short Sale is being offered. If it does not, the Short Sale cannot be executed. Securities Lending is exempt from these restricitions, as well as certain reporting restrictions - this is an important difference.  

Securities lending is part of a controlled risk investment strategy that can provide (relatively) substantial rewards. If you have a superannuation fund with one of the major companies, they will have a portfolio that has global exposure to the companies that compose the major indices. It is a certainty that they will be using securities lending as a means of enhancing their portfolio performance, both in the rate of return to the investors, and in using the collateral generated as an effective tool in diversifying the existing asset mix into other investments such as property, fixed income or other equities. For example; National Australia banks' National custodians division is one of the largest share custodian companies in Australia and they have made no secret of the securities lending that they facilitate to increase their profit. 

The tax situation is also not greatly affected due to lending, for income tax purposes within Australia the lender is deemed to 'own' the shares during the loan period. Therefore there is no detrimental effect on dividend imputation (franking) or the discount on capital gains (after the qualifying period).

Lending therefore enhances the portfolios return that would otherwise consist of the capital growth and dividends return (plus franking benefits). The subsequent diversification and enhanced return offers some protection against downturns in world markets and is a means of offsetting administration costs. Global custody banks, which are institutions that keeps custody of stock certificates and other assets of a mutual fund, individual, or corporate client offer securities lending as a means of distinguishing themselves from the mainstream.

Why should it interest me?

As explained earlier, Securities lending is widely used by institutions and stock brokers as it enhances their returns and they can therefore increase their profits, especially if they do not return the high percentage gains to the fund holders and investors.

For example: If the underlying market that your portfolio is exposed to has risen by 10% and a superannuation fund can return 20% by utilising strategies such as securities lending, it is probable that if you receive 9% after costs, you will probably not complain too much. However the institution has profited by 11% with no risk to themselves. It is possible to expose yourself directly into specialist funds that pass on the increased returns and savings in administration costs. By introducing low levels of leveraging the gains can be increased and as long as the fund manages the risk adequately, there should be limited downside risk.

What are the downsides?

Securities lending has (rightly) received a lot of criticism due to the ability of Hedge funds to borrow stock on a company, and then subsequently sell the stock (with no adherence to the up tick rule - see above) to deflate the share price in the hope of triggering margin calls. The subsequent crash in the price of the stock then allows the Hedge fund to buy back the original position cheaply and pocket the difference as profit. When mixed with a few well placed rumours, the profits can be substantial.

Therefore the situation arises that a custodian (which exists to securely hold stock for managed funds, individuals etc) in the pursuit of profit, lends that stock out to companies and funds whose intention is to cause the stock price to drop and then profit from that drop. Who is the loser? obviously the stock owner is the loser. They entrusted the stock to a custodian in the belief that the custodian would be looking after the stockholders interests.

In Early 2008 a wave of  short selling by Hedge funds claimed a number of victims; ABC learning Centres, Allco Finance Group, Centro Properties, HSBC to name but a few. There have been calls for tighter regulation and disclosure rules for the market.

The lack of regulation that surrounds securities lending is also an issue, The Australian Securities Lending Association has a list of 36 Australian securities lending institutions and  a code of conduct. However, if you sign a securities lending agreement you sign away the beneficial ownership of the shares to the lender, this can leave you as an unsecured creditor behind the banks if the lender goes into receivership.