investors have been the largest equity lenders. With the beneficial
owner’s permission, custodian banks can act as lending agents for the beneficial
owners by lending shares to borrowers. The custodian bank and the
beneficial owners share in any revenue generated by securities lending with
a prearranged fee sharing agreement. A typical arrangement would have
75% of the revenue going to the beneficial owner and 25% going to the
agent bank.3 Depending on the type of assets being lent and the borrowing
demand, lending revenue earned by the owner of the security may completely
offset custodial and clearance fees for institutional investors.
In addition to traditional custodian bank lenders, a number of specialty
third-party agent lenders have entered the equity lending market
over the past several years. Under this structure, the assets are lent by an
agent firm who represents the beneficial owner but is not the custodian
of the assets. Once a loan is negotiated between the agent lender and the
borrower, the agent facilitates settlement by working with a traditional
custodian bank in arranging delivery of the shares to the borrower. In
comparison with custodian banks, these noncustodial lenders often
offer advantages to the beneficial owner such as more specialized
reporting, flexibility, and more lending revenue.
As an alternative to agency-lending arrangements, the beneficial
owner may decide to lend assets directly to borrowers. Increasingly,
owners choose to lend their assets via an exclusive arrangement, where
the owner commits his assets to one particular borrower for a specific
period of time. For example, in recent years, the California Public
Employees Retirement System (CalPERS) has lent its portfolios through
an auction system with the winning bidder gaining access to the portfolio
for a predetermined period of time. This arrangement guarantees a
return to the beneficial owner for loaning out the assets. Another avenue
that some institutions have explored is managing their own internal
lending department, therefore having total control over the lending process
and keeping all of the revenues generated. Due to the large costs
involved in setting up a lending department and the infrastructure
needed, this option is only available to the largest institutional investors.
Lender’s Rights
The owner of a stock retains beneficial ownership of the shares it lends. This
status gives the owner the right to receive the value of any dividends or distributions
paid by the issuing company while the stock is on loan. However,
rather than being paid by the company, the dividend and distributions are
paid by the borrower. This is referred to as a substitute payment. The beneficial
owner is also entitled to participate in any corporate actions that occur
while the security is on loan. For example, in the case of a tender offer, if the
beneficial owner wishes to participate in the offer and the borrower is
unable to return the security prior to the completion of the offer, the borrower
is required to pay the beneficial owner the tender price. The only right
the lender gives up when lending their assets is the right to vote on a security.
However, the lender generally has the right to recall the loaned security
from the borrower for any reason, including to exercise voting rights.
In the event of a recall, the borrower is responsible for returning the
shares to the lender within the normal settlement cycle. For example, if
the beneficial owner sells a security that is on loan, the agent lender will
send a recall notice to the borrower on the first business day after the
trade date (T + 1) instructing borrower that the shares need to be
returned to the agent within two business days (T + 3). If the shares are
returned within this period, the custodian can settle the pending sell
trade. If the borrower fails to return the shares by (T + 3), the agent
may buy shares to cover the position, therefore closing out the loan.
Lender’s Risks
There are three types of risk the beneficial owner faces when lending
stock: investment risk, counterparty risk, and operational risk. Investment
risk involves the choices that the beneficial owner or their agent
makes in investing collateral. Some lenders are reluctant to take risk in
their reinvestment of collateral, and they invest primarily in overnight
repurchase agreements or other very low risk investments. Other lenders
look to achieve extra income by investing in higher risk assets. For example,
lenders can earn more return by investing in longer term investments
and short-term corporate debt with lower credit ratings. It is the beneficial
owner’s responsibility to monitor the investment of the collateral to
manage these risks. Even if there is a loss from investing the borrower’s
collateral, the beneficial owner is still responsible for returning the borrower’s
full collateral when the security is returned.
Counterparty risk is the risk that the borrower fails to provide additional
collateral or fails to return the security. The beneficial owner can
manage this risk by approving only the most creditworthy borrowers
and by imposing credit limits on these borrowers. Furthermore, the fact
that collateral is marked to market daily allows lenders to buy shares to
cover the loan if the borrower will not return the shares.
The last major risk to the beneficial owner is operational risk. This
is the risk that various responsibilities of the agent lender or borrower
are not met. This could be the failure to collect dividend payments, the
failure to instruct clients on corporate actions resulting in missed profit
opportunities, the failure to mark a loan to market, and the failure to
return a security in the event of a recall. These risks can be minimized
by maintaining a good lending system which tracks dividends, corporate
actions, and the collateralization of loans.
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